Ebook Credit Card Securitization And Regulatory Arbitrage
Between 1980 and 2002, the average annual growth rate of consumer credit (93% of which is in the form of credit card receivables) was over 12% (Federal Reserve statistics reported in Deutsche Banc Alex. Brown 2002). Growth rates prior to 1987 averaged upwards of 15%. After 1987, securitization became integral to credit card industry growth. Citicorp led the sector through the capital crunch of the early 1990s, increasing its credit card accounts 42% between 1990 and 1992 by securitizing nearly two-thirds of its $33 billion portfolio (Card Industry Directory). Securitization helped restore the consumer finance sector to double-digit growth in 1993 and pushed growth to 18% in 1994 and 22% in 1995. By 1996, securitized credit card receivables exceeded $180 billion, at which time credit cards comprised 48.4% of the non-mortgage ABS market. By 2001, credit card securitization had grown to $339.1 billion. In 2001, credit cards accounted for 28.2% of the non-mortgage ABS market (Bond Market Association 2003), and securitized credit cards amounted to about half of all consumer credit.
It is well known that credit card banks have been among the most intensive and innovative users of new market-oriented tools for financing their loans. Credit card bank reliance on these innovations has been an entirely private matter. Unlike the mortgage market, there are no government-sponsored agencies (GSEs) purchasing credit card receivables.
A less well-known fact about the last decade’s financing of credit card receivables by banks is the diversity of bank behavior. Some banks financed the vast majority of the credit card receivables they originated with off-balance-sheet finance, while others (roughly 275 of the top 300 issuers in 2000) retained all of the receivables they originated, financing them with bank equity and debt as they would other types of bank loans. Banks that retain the receivables on-balance-sheet, however, accounted for only around 40% of total outstanding receivables in 2000. Hence, credit card asset-backed securitizations (ABS) are relatively small in number but large in asset share.
Observers of the phenomenal growth in credit card securitization over recent years have pointed to numerous advantages that come from securitizing assets. These include the carving up of risks into senior-subordinate tranches to better match the preferences of potential financing sources, reducing the adverse-selection costs of financing receivables by isolating credit card accounts and placing them under the continuing scrutiny of market participants (including securities purchasers, ratings agencies, credit enhancers, and conduit trustees), and reducing the costs of maintaining equity capital by avoiding the high regulatory equity capital requirements attendant to on-balance-sheet holdings of bank credit card receivables.
That last advantage has been questioned by regulators, who have become increasingly concerned that off-balance-sheet finance is often a form of undesirable “regulatory arbitrage.” Regulators have accused banks of overstating the value of their retained interests in securitized assets and of keeping the risks of securitized assets on their balance sheets by providing implicit recourse to securitization trusts. Regulators argue that securitizing banks have effectively reduced their regulatory capital requirements without commensurately reducing their asset risk.
The controversy over the equity capital savings resulting from credit card securitization and, more generally, from bank securitization of all assets revolves around the question of whether the level of capital maintained by securitizing banks is adequate in light of the assets originated and managed by those banks and the attendant risks the banks retain from their on and off balance sheet activities. Regulators see securitization’s subversion of capital requirements as a threat to financial system risk and as an attempt to reap implicit subsidies from the federal safety net. Bankers argue that, for some classes of assets, regulatory capital requirements are too high relative to what should be required as equity capital backing. Banks financing credit card receivables, in particular, see regulatory arbitrage as a means of restoring efficiency to credit card intermediation by reducing capital requirements to more reasonable levels, not as an abuse of the safety net.
Our goals in this paper are to measure the extent to which banks engage in regulatory capital arbitrage by retaining some risks from off balance sheet assets, and evaluate the desirability of that regulatory arbitrage.
Section II reviews the alleged problem of regulatory arbitrage through securitization with implicit recourse. Regulators argue that if banks believe that regulatory capital requirements are excessive for credit card receivables, then banks should securitize those receivables through “true sales” and not retain risk in securitized assets through implicit recourse. The ability to retain risk opens the door to capital regulation arbitrage and abuse of the government safety net (purposeful reductions of capital relative to risk retained by the originating bank). The typical motivation for prudential minimum capital regulation is to protect against safety net abuse (Shadow Financial Regulatory Committee 2000). We review the evolution of the “safety net abuse” view of securitization with recourse and the attempts by regulators to limit the use of implicit recourse, which have been ineffectual to date.
In Section III, we show that, in theory, securitization with implicit recourse may be efficient, rather than an attempt to abuse government safety net protection by maintaining inadequate capital. We call this the “efficient contracting” view of securitization with implicit recourse. A combination of excessively high regulatory capital requirements, problems of adverse selection in valuing credit card receivables, and institutional prohibitions on non-bank credit card intermediation may make bank securitization with recourse the best available means of financing credit card receivables. Furthermore, the contracting structure through which implicit recourse is provided (i.e., where recourse from originators avoids the triggering of costly early amortization) can be seen as a means of ensuring credible, incentive-compatible increases in the allocation of risk to originating banks in bad states of the world, when adverse-selection costs make that reallocation of risk efficient. In a dynamic context, that voluntary form of assistance can also be an important means of signaling credit quality by originators.
Section IV analyzes the asset characteristics of credit card banks and the relationship between capital structure and risk management decisions (in 1996 and 2000), both for those that securitize and those that do not. We distinguish between the empirical implications of the “safety net abuse” and “efficient contracting” views of securitization with recourse. We show that the behavior of securitizers is more consistent with the efficient contracting view than the safety net abuse view of securitization with implicit recourse. The amount of capital relative to risk retained by originating banks is determined by the market and is substantially above the minimum required by regulation. Rather than being set with the intent of extracting a subsidy from the government safety net, reductions in effective capital ratios through securitization with partial recourse seem to be the outcome of market judgments about capital adequacy relative to risk. Section V concludes.
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