How the U.S. Saved the European Banking System

Good description in a recent CEPS report of how the U.S., via its AIG bailout, temporarily saved the over-leveraged European banking system.

leverage But the AIG case shows the importance of another link across financial markets, namely massive regulatory arbitrage. The K-10 annex of AIG’s last annual report reveals that AIG had written coverage for over US$ 300 billion of credit insurance for European banks. The comment by AIG itself on these positions is: “…. for the purpose of providing them with regulatory capital relief rather than risk mitigation in exchange for a minimum guaranteed fee”. AIG thus helped to organise regulatory arbitrage on a gigantic scale. A formal default of AIG would have had a devastating impact on banks in Europe. This explains why AIG’s problems had sent shock waves through the share prices of European banks. For the time being the US Treasury has saved, inter alia, the European banking system, but given that AIG is to be liquidated European banks now have to scramble to find other ways of obtaining the ‘regulatory capital relief’ they appear to need urgently.

Get all that? It’s less well known than it should be, but Europeans banks have long been gaming their regulators, having far less than the actual capital reserves that they needed given their balance sheets. AIG filled the hole, selling credit defaults swaps to European banks via which they could tell regulators that they were adequately covered — at triple-A, no less — while carrying less cash than required.

I’m not suggesting that this was an outright scam. Instead, it was just another example of how an over-connected financial market with too little slack ended up being under-collateralized and far riskier than any of its participants expected. And it helped that we had been living through a period of relative crisis quiet, boosting the illusion that all was eternally well.

The upshot, of course, is that the European banks are generally more levered than their U.S. counterparts. With that coming into plain view in the absence of the regulatory arbitrage cover provided by AIG’s swaps, that helps explain what we are now seeing on the Continent at present.

More here.