Does Deutsche Bundesbank want research that now “discovers” bank regulation mistakes it should have known of before?

Discussion Paper: Deutsche Bundesbank No 40/2015

Arbitraging the Basel securitizationsframework: evidence from German ABS investment

Matthias Efing: (Swiss Finance Institute and University of Geneva)

"Non-technical summary Research Question: The 2007-2009 financial crisis has raised fundamental questions about the effectiveness of the Basel II Securitization Framework, which regulates bank investments into asset-backed securities (ABS). The Basel Committee on Banking Supervision (2014) has identified “mechanic reliance on external ratings” and “insufficient risk sensitivity” as two major weaknesses of the framework. Yet, the full extent to which banks actually exploit these shortcomings and evade regulatory capital requirements is not known. This paper analyzes the scope of risk weight arbitrage under the Basel II Securitization Framework. 

Contribution: A lack of data on the individual asset holdings of institutional investors has so far prevented the analysis of the demand-side of the ABS market. I overcome this obstacle using the Securities Holdings Statistics of the Deutsche Bundesbank, which records the on-balance sheet holdings of banks in Germany on a security-by-security basis. I analyze investments in ABS with an external credit rating to uncover risk weight arbitrage on the demand-side of the ABS market."

Results: The analysis delivers three main results.

“First, I provide security-level evidence that banks arbitrage Basel II risk weights for ABS. Banks tend to buy the securities with the highest yields and the worst collateral in a group of ABS with the same risk weight (and, therefore, the same capital charge). My findings corroborate the hypothesis that institutional invsstors bought risky ABS to some extent for motives of regulatory arbitrage.”

What does that mean? That banks, for the “same risk weight”, buy what offers them the highest expected risk adjusted return on equity. Is that not what they are supposed to do? Would we, or the regulators like banks to minimize their risk-adjusted returns on equity?

"Second, banks operating with low capital adequacy ratios close to the regulatory minimum requirement are found to arbitrage risk weights most aggressively. From a financial stability perspective this finding is troubling as it smplies that the presumably more fragile banks are also most pervasively optimizing the very capital regulation designed to constrain them." 

What does that mean? That banks that are more pressured by capital constraints might act more aggressively? Is that not to be expected? 

"Third, banks with tight regulatory constraints buy riskier ABS with lower capital requirements than other banks. The ABS bought by banks that arbitrage risk weights, promise an as much as four times higher return on required capital than the ABS bought by other banks."

What does “riskier ABS with lower capital requirements” mean? ABS perceived ex ante as safer have lower capital requirements. It looks like confusing ex post realities with ex ante perceptions. 

What does ”as much as four times higher return on required capital” mean? Simply that capital requirement minimization has become more important in delivering expected risk-adjusted returns on equity than the correct analysis of risk.

My conclusion:

This paper just evidences that the most important research needed is that which explains how on earth the regulators of our banks could have come up with something so stupid as the portfolio invariant ex ante perceived risk based capital requirements for banks.

And again how these regulations distort the allocation of bank credit to the real economy remains a non-issue.

Here is a link to a brief aide memoire on some of the fundamental Basel capital requirements’ mistakes.