Creditflux Newsletter

One of the biggest regulatory changes taking place in the US and Europe is the introduction of risk-retention rules for securitisation. But this is the right solution to the wrong problem.

The rationale for these skin-in-the-game rules is summed up by the Federal Reserve in its October report on the topic. It said: “By retaining a portion of the credit risk, the securitiser and/or originator will have an incentive to exercise due care...”

The assumption behind this description, and it is one universally shared by regulators and politicians, is that banks are the “right” place to keep credit risk. It is dangerous and distasteful for banks to sell assets, they imply, and buyers must be protected from those who would engage in this fundamentally unnatural activity.

It is hard to find any public explanation by regulators or politicians of why they see banks as the natural home for credit. When they do explain their attempt to rein in what they often call the “shadow banking” system it is on the grounds that it, unlike the banks, is unregulated. This is a feeble argument. Regulators have done a dreadful job of regulating banks.

But the regulators are right that the securitisation market has major flaws and needs better regulation. With securitisation, true credit analysis is often forgotten as investors buy up chunks of risk as if they were widgets. The law makers are also correct that investment products should be put together or overseen by bodies whose interests are aligned with those of investors.

However, the flaws of securitisation and other forms of “shadow banking” fade into insignificance compared with what is the biggest vulnerability in the financial system. This, as our guest columnist Joe Pimbley argued in Creditflux in August, is the fatal mismatch between banks’ long-dated assets and their volatile, short-dated liabilities.

That is why risk retention is addressing the wrong problem. Banks such as Anglo Irish, Washington Mutual and Northern Rock did not come to grief because they sold off too much risk. Their problem was that they held on to too much.

For the safety of the financial system, and the good of investors, vehicles that channel capital into credit should have three qualities. First, their workings and contents should be transparent to investors. Second, their assets should be chosen by individuals whose interests are aligned with the providers of capital. And third, their funding should match, as closely as possible, the maturity of their assets.

By these measures, banks score dreadfully. They are opaque, riddled with conflicts of interest and their capital structures are a time bomb. Securitisation and money market funds do better, but are far from perfect. CLOs, with a manager choosing and overseeing the assets, are much better than either banks or static forms of securitisation.

Now is the time for the market to create other alternative vehicles to channel capital into different areas of credit. There are already signs of this, with the growth of business development companies and other closed-end listed vehicles. Another promising idea is for low levered cash-like credit funds to provide an alternative to cash deposits.

And we need to find a better phrase than “shadow banking” to describe this new financial services infrastructure. This sector – perhaps we should call it “open source finance” – is not a ghostly imitator of banking. If it is built and regulated properly, it will do the job of intermediating between investors and borrowers better and more safely than that ancient confidence trick called banking.