In October 2008, the month after the collapse of Lehman and as the extent of the damage to the banking system was becoming apparent, I was trying to think of a way of structuring loans to pass through changes in the cost of the bank's capital that supported them.
I realized that the only perfect solution would be for a borrower's shareholders to actually provide the capital to support its loan, and that this not only solved the problem of the cost of the bank's capital but also the more fundamental problem of its scarcity. After all, which investors could be more incentivized to provide a bank with new capital at the height of a credit crunch than the owners of a firm whose new loan that capital would facilitate. This would directly address the problem of pro-cyclicality in bank lending. I also saw that this would provide the element of real market discipline that banks had been missing, and could be a pillar of any new capital regulation.
Since then idea developed to address theoretical and practical issues as they arose, the main ones being (i) that the bank not being seen to fund its own capital, (ii) overcoming the divide between the loan origination and capital management functions within banks, and (iii) a practical form for the capital itself. This post provides a history of that development. Part 2 sets out the final product, the Regulatory Capital Swap.
Blog/Press coverage from Felix Salmon and the Sydney Morning Herald by Michael West.
