The Corner

A Cautionary Tale

John Carney: “How Bank Regulation Helped Destroy AIG“:

… Banks around the world operate under rules that determine how much capital they must hold in reserve. The rules say that a riskier the assets held by a bank, the larger the reserve they have to maintain. One way to reduce the riskiness of your assets was to buy insurance on them. This created a huge demand for credit default swaps as a kind of regulatory arbitrage, banks trying to comply with regulations while maximizing their own profits. […]

This wasn’t some nefarious secret. AIG sold hundreds of billions of credit default swaps to European banks for precisely this regulatory reason. And it wasn’t shy about it. It revealed in its annual statement that about $379 billion of the $527 billion in AIG’s default swap portfolio “represents derivatives written for financial institutions, principally in Europe, for the purpose of providing them with regulatory capital relief rather than risk mitigation.”

The disaster occurred when the underlying assets turned toxic. AIG’s credit default swaps were like insurance policies on these assets, but as Carney points out, “There’s no way it could make good on even a tiny fraction of them.”

This story, about how banking regulations helped create the demand for a financial product that now has crippled the world’s largest insurance company, is another reason to be cautious about building a new regulatory framework. You never quite know what monsters you could be creating.