Securitization And Bank Regulation

Felix Salmon had a gem of a post at Portfolio.com the other day. In it he talks about low-information assets and high-information assets. The former being things like bank deposits and money market funds and the latter being stocks and CDO’s.

One of the points of the post was that the transformation of low-information assets like bank loans into high-information assets like CDO-squareds may have well led a lack of monitoring of the underlying credits. As bank loans were securitized and sold did the ultimate purchasers fail to follow-up on their responsibility to track the performance and risk profiles of the loans that made up the security. Salmon thinks that indeed this did happen and that one consequence of the meltdown may be a return to hands on credit analysis.

The post raised a question in my mind. What effect did the securitization of bank loans have on the bank examination process?

Historically, bank examiners from the Fed, OCC, OTS or FDIC have reviewed bank loan portfolios on a loan by loan basis as well as on a more macro level. I can remember numerous rather heated discussions with them regarding their judgment with respect to specific loans, a few of which I won and more that I probably lost. At any rate, the examination process served to not only identify specific problem loans in an individual bank but highlight deteriorating conditions in industries. Information developed at the bank level was fed back through the regulatory apparatus and provided a sort of early warning system of potential dangerous sector risk. It wasn’t perfect but it was functional.

So how did securitization affect the regulatory process? If a bank had effectively eliminated its credit risk for a loan via derivatives did the examiner proceed to review the loan or simply conclude that in the absence of risk review was unwarranted? If indeed that was the case then the regulatory system lost valuable information. Had it possessed that information it might well have concluded that lending and leverage were running far ahead of the norm and acted to rein in the banks.

This is all pretty speculative stuff and I doubt that anyone is going to own up to the fact that they were AWOL during this period, if in fact they were. We shoudln’t, however, be surprised that a lot of bad loans were made if no one was monitoring them after the money was out the door.

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