AIG, Foreign Banks, and the Role of Regulation

There is an underlying story in the AIG fiasco that does not get adequate attention. See, for instance, Joe Nocera's generally excellent piece in the NYT today, or for a piece from last September that makes my point really well, see this article in International Financial Law Review.

AIG was engaged in a big way in regulatory and ratings arbitrage. Many commentators fault the regulatory system for failing to monitor and control AIG, even though there were regulators sitting in AIG's US headquarters continuously. Perhaps part of the problem was that the Financial Products Group was based in London. It is probably a lot harder to regulate things offshore.

And why was the FPG in London? Well, I cannot find figures on it, but there is certainly a lot of qualitative evidence that European banks (French, German) were very big buyers of AIG's credit default swaps (read: insurance). Why? Because Basel II, the international banking regulatory accord, specified the amount of capital required to be held against different classes of assets. If you could get a AAA rating on assets (insurance, I think, was actually the key), then the amount of capital you needed was much lower (doesn't this sound like the issue with the US investment banks and leverage -- indeed it is). So how can we get a AAA rating on some of our subprime assets? In steps AIG, with their credit default swaps.

So the banking regulatory system, set up to a great extent by the Europeans, created a demand for the insurance that AIG was more than willing to sell.

What is to blame? The regulation that created the demand, or the lack of regulation that allowed AIG to persist? Not clear to me. Some of both, no doubt -- and some serious lack of oversight at AIG themselves.

Perhaps it does come back to what more and more people tell me: you need the overall leverage restrictions on the banking system. If you start parsing risk and saying these kinds of assets need x% capital, and another kind of asset only y%, you are asking for regulatory and ratings arbitrage. And just like with illegal drugs, once the demand is created, it is very hard to restrict supply.

I wonder how much European banks really are benefitting from the US taxpayer's bailout of AIG. Why is Treasury and the Fed so willing to do this? Are they extracting something from the European banks? How long will it take before we hear about the sorry state of European banks (of course some of that has come out already, but I suspect not nearly all of it).