Bankers’ New Fix May Cause Harmful Addiction

European regulators and policy makers have moved quickly during the pandemic to loosen banks’ capital rules to keep the lending taps open. The latest wheeze is to make it easier for lenders to buy insurance against the risk of their borrowers defaulting. The danger with this fix is that the industry gets hooked on an unproven piece of financial engineering that adds even more complexity to the banking system.

It isn’t surprising that the European Commission, which is pushing for the change, is eager to help the lenders. Unlike in the U.S., the continent’s companies rely on bank lending for most of their borrowing. What’s more, the European Central Bank delivered grim news on Tuesday: Some banks might not have enough capital to meet minimum requirements by 2022 in the event of a severe economic downturn.

Traditionally, banks have securitized their loans by packaging them together themselves and selling the exposure to other parties. But the Commission is proposing that they should be allowed to do “synthetic securitizations” too, where lenders buy a guarantee against potential loan losses — typically in the form of a derivative — from a hedge fund or insurer. The difference with this approach is that the assets being insured remain on the banks’ balance sheets, meaning they could now free up capital.

These so-called “capital-relief trades” were seen as toxic in the aftermath of the financial crisis, when they were used for nefarious purposes, and Europe has taken years to find ways to make them less open to abuse.

Regulators have found ways to reduce some of the risk: Under the Commission’s proposal, those providing the credit protection will probably have to post collateral against the transactions, shielding the bank from the danger of a counterparty not meeting its promise to cover losses. But not everyone will be reassured. As I’ve argued before, moving risk outside the regulated banking industry could do more harm than good without adequate protective measures.

And this could be a big market, even with the collateral requirement. Yield-starved investors have been knocking on banks’ doors, eager to offer guarantees on anything from U.S. corporate loans to pools of loans to small and medium-sized companies.

Hard numbers are hard to come by because most deals tend to be bilateral transactions with little disclosure, but data compiled by the European Banking Authority show synthetic deals are already more popular than traditional securitizations. They had a total value of about 126 billion euros ($148 billion) as of last year. These deals tend to be most popular among the larger banks and attract a narrow group of buyers, according to the EBA. Deutsche Bank AG reportedly cut its risk to the now bankrupt Wirecard AG with one such transaction.

Regulators also hope that letting banks treat synthetics like actual securitizations will bring more transparency to the market and make it clearer where risk has shifted.

Nevertheless, bank leaders shouldn’t over-rely on the appetite for risk from investors that could just as easily vanish. A rise in company defaults — an inevitability when governments eventually halt their pandemic spending — could dampen demand. Best for Europe’s lenders to focus on how they can help themselves.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Elisa Martinuzzi is a Bloomberg Opinion columnist covering finance. She is a former managing editor for European finance at Bloomberg News.

©2020 Bloomberg L.P.

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