The Future Regulation of Securitization
It has to be remembered that while offering high loan-to-value mortgages to those of limited means was one cause of the US subprime mortgage collapse, the problems were exacerbated by the fact that banks and financial institutions went on to leverage this risk through the securitizations that they put in place on residential mortgages. In all of this, it is very difficult to distinguish between what was intrinsically a bad business model, and what was the bad execution of an intrinsically sensible idea.
In principle, collateralized debt is a good thing for the sector, in that it frees up capacity on the originator’s books and stimulates investment. However, lending on the assumption that markets can only ever go up is not good business, and, if the originators then write CDOs on the back of these, the resulting creation can be a tremendously toxic asset, if its risk/return characteristics and vulnerabilities are not fully understood. It seems clear that once the dust has settled, securitization will not be abandoned by the market entirely, even if it, in future, follows a different path. For the originator, it is a very useful tool to have available and there are sound, prudent ways of dealing with the objection that securitization creates moral hazard by moving risk away from the originator.
The rethinking of Basel II is likely to mean that regulators will demand that banks hold more and better quality capital, particularly in good times, although they will only be asked to increase their capital ratios slowly, as the world works its way through the recession. The overall framework is likely to remain largely unchanged, but the treatment of particular product types and risk classes will change, particularly so far as the trading book is concerned, into which too many positions were placed that did not, in the event, have sufficient liquidity to be treated in this way.
The Shape of Regulation to Come
What the industry has today is some visibility on the direction of the elements of change in the Basel II framework. Charges for market risk will increase. Additional capital will be set aside as the world economy recovers. There will be much more rigorous stress testing of the elements that go to make up capital adequacy. And liquidity guidelines will be seen as an essential complement to the capital regime. The FSA, for example, has issued liquidity guidelines that it wants to see implemented by early 2010. These are major proposals and have the potential to have impact on governance models, business models, and bank business activities. There is some cloudiness because these proposals and their implications are still being worked through, but it is clear that the industry agrees that liquidity merits more detailed regulation, although there remains much debate about the specific details of the regulation.
It is also clear that banks are going to need to revisit some essential components of their strategy and business models. The changes being proposed may well result in pressure for more restricted business models than we have seen for banks, and for operating models that offer less incentive for risk-taking. It must be said that these models are not really geared to encouraging more lending, which is what governments want, at least in the short term.