Creditflux Newsletter

We shouldn’t be surprised by all the regulatory capital fund presentations we’re seeing. More regulation and higher capital requirements for banks begets more focus on the efficient use of that capital and greater rewards for those who can design techniques, funds and structures around it.

As a result, the same people who led the charge on designing some of the products associated with the credit bubble and subsequent crunch are now using their skills to navigate the new capital rules.

 When the credit structuring division of Megabank was closed down and he was “let go”, I thought my former colleague Heath Robinson would retire to his country estate to tend to his collection of classic cars. Having crashed and burned the credit markets he seemed content to re-engineer his cars and race them in ever faster circles until they, too, crashed and burned. Imagine my surprise when I heard that he had secured a large commitment from a well known hedge fund to back a reg cap fund idea.

When Wolseley met him, Heath was clearly relishing the challenge of working round the new, more convoluted regulations. He reassured me that some real risk transfer was now required for potential customers to get regulatory capital relief, so his fund needed a couple of real credit traders to manage some of the risk that it would have to manage.

With funding also evolving in response to regulatory change, and now looking more like private equity than the kind of structures that worked pre-crisis, it seems that shadow banking – that area demonised as an insidious cause of instability – is returning to take advantage.

Are regulators worried? Not according to one individual involved in bank regulation to whom Wolseley spoke. Her focus was on whether risk was being moved out of the banking system. If risk was genuinely being moved into pools of capital outside her area of responsibility, this was a good thing. She wanted to make sure banks could meet the challenges they faced in raising the necessary capital to achieve minimum capital adequacy standards. She was indifferent as to whether this was achieved by reducing the numerator in the capital ratio equation or increasing the denominator.

The UK government’s Independent Commission on Banking is soon to release an interim report that will likely provide further opportunities for reg cap funds. The recommended creation of a “moat”, or “ring fence” around core, retail banking and payments businesses, if adopted, will create incentives for Heath Robinson and his ilk to repackage core assets so that they can be smuggled out over the drawbridge. There will also be greater incentives for credit markets to conduct core functions outside these ring-fenced entities.

So where does this leave us? With an important “new” profitable business line, of course. In fact shadow banking and reg cap funds never went away. They have certainly been out of fashion for a few years, but unless regulators choose to take a stance against their use by regulated banking entities (and how can they?) Wolseley would expect to see many well known, reputable names following the leads of Cheyne and Aladdin into the reg cap space.

FSA chairman Adair Turner once opined that society would be no worse off if we lost the formula for the CDO squared. It’s ironic that the actions of Lord Turner’s fellow regulators have led to a resurgence of the very innovators who created that tricky product.

Wolseley is a leading practitioner in the credit market. Feedback is welcome at wolseley@creditflux.com