Wednesday, September 24, 2008

The Sopoforics are finally wearing off in Europe...

Note the phrase "regulatory arbitrage". Trade conflict memes abound in this piece.

FT: European banking on borrowed time
By Daniel Gros and Stefano Micossi

The US financial system is being nationalised. The piecemeal approach followed so far had clearly not been working. Hence the US political system is working overtime to reach a bipartisan agreement on a systemic solution. The centrepiece is already known: the US government is going to buy $700bn (€480bn, £380bn) of the so-called “toxic” assets. More measures are certain to follow as the banks will require recapitalisation to the extent that they make losses. As a result, the US government will soon own a large share of the US banking system. If the details are generous enough, this should be sufficient finally to restore orderly market conditions. Can Europe be far behind?

The synchronised movements in global markets over the last few weeks have shown that contagion works on the way down and on the way up.

But the case of AIG, the US insurer, also shows the importance of another, hidden, link across financial markets, namely massive evasion of regulatory requirements. AIG’s last annual report reveals that it had written coverage for more than $300bn of credit insurance for European banks. The comment by AIG itself on these positions was that they were “for the purpose of providing them with regulatory capital relief rather than risk mitigation in exchange for a minimum guaranteed fee”. Thus, a formal default by AIG would have exposed European banks to large increases in regulatory capital requirements, with possibly devastating effects on their ratings and market confidence. Thus, the US Treasury has saved, inter alia, the European banking system.

The extent of regulatory arbitrage can also be seen in the very large gap between overall leverage ratios and the official regulatory ratios. The dozen largest European banks have now, on average, an overall leverage ratio (shareholders’ equity to total assets) of 35, which has actually increased so far this year, compared with less than 20 for the largest US banks. But at the same time most large European banks also report regulatory leverage ratios of close to 10. This is partly due to the fact that the massive in-house investment banking operations of European banks are subject only to limited regulatory capital requirements. Another part of the explanation must be regulatory arbitrage, for example, through the credit insurance offered by AIG.

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