Bank capital regulation, ABS-CDO exposures and the cost of restoring solvency

Purpose This study examines how bank capital regulation for highly rated, private-label securitization tranches, and related policy changes may have exposed asset backed securities collateralized debt obligation (ABS-CDO) issuing bank holding companies (BHCs) to costs of restoring solvency in 2008–2009. Design/methodology/approach The study uses: 1) breakpoint analysis to examine the coincidence between regulatory changes and changes in ABS-CDO issuance from 2001 to 2007, and 2) panel data methods to a) estimate treatment effects of BHCs commenting on the regulation and b) relate ABS-CDO exposures to average estimated debt guarantees, reflecting the cost of restoring solvency. Findings Breakpoint analysis suggests growing ABS-CDO issuance began with the Recourse Rule. Dynamic treatment effects for large BHCs commenting on the Recourse Rule show estimated debt guarantees for these BHCs increased only from Q3 2008–Q3 2009, peaking at 60bn in Q1 2009, with negligible effects for the control group. From Q1 2008–Q1 2009, among trading assets, only ABS-CDO holdings have a large positive association with estimated debt guarantees. Practical implications To show some costly, unintended consequences of risk-based capital regulation. Originality/value The study addresses the lack of detailed BHC ABS-CDO holdings by estimating daily issuance as a proxy for supply to identify when growth began, and by using BHC comment letters to identify how the rule change may have exposed those BHCs to costs of restoring solvency.