How The Banks Used AIG's Swaps To Dodge Banking Rules

Yesterday we spent a good deal of time explaining how AIG built its credit default swap business–the business that ultimately wrecked the largest insurance company in the world–on top of banking regulations. Basically, banking regulations encouraged companies to buy cheap swaps so that they could treat risky investments as almost risk-free. This, in turn, allowed them to take money out of their reserves and buy more risky assets, which they then covered up with more credit default swaps.

The term of art for this was “regulatory arbitrage.” What’s truly distressing is that it was all happening right out in the open, with AIG openly admitting that a huge part of its business was based on providing “regulatory capital,” which is to say allowing banks to use more of their balance sheets to take riskier bets.

Joe Nocera’s recent column in the New York Times does an excellent job of explaining how this worked:

The regulatory arbitrage was even seamier. A huge part of the company’s credit-default swap business was devised, quite simply, to allow banks to make their balance sheets look safer than they really were. Under a misguided set of international rules that took hold toward the end of the 1990s, banks were allowed use their own internal risk measurements to set their capital requirements. The less risky the assets, obviously, the lower the regulatory capital requirement.

How did banks get their risk measures low? It certainly wasn’t by owning less risky assets. Instead, they simply bought A.I.G.’s credit-default swaps. The swaps meant that the risk of loss was transferred to A.I.G., and the collateral triggers made the bank portfolios look absolutely risk-free. Which meant minimal capital requirements, which the banks all wanted so they could increase their leverage and buy yet more “risk-free” assets. This practice became especially rampant in Europe. That lack of capital is one of the reasons the European banks have been in such trouble since the crisis began.

At its peak, the A.I.G. credit-default business had a “notional value” of $450 billion, and as recently as September, it was still over $300 billion. (Notional value is the amount A.I.G. would owe if every one of its bets went to zero.) And unlike most Wall Street firms, it didn’t hedge its credit-default swaps; it bore the risk, which is what insurance companies do.

It’s not as if this was some Enron-esque secret, either. Everybody knew the capital requirements were being gamed, including the regulators. Indeed, A.I.G. openly labelled that part of the business as “regulatory capital.” That is how they, and their customers, thought of it.

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