By Richard Robb

In their classic routine, Carl Reiner asks Mel Brooks, the 2000 Year Old Man, to explain how he has managed to live for so long. Brooks replies that he avoids fruits, vegetables, meats, grains - each of which causes some comic side effect. All that’s left for him is “cool mountain water.” “Just that,” the old man says, “and a stuffed cabbage.” Reiner asks whether stuffed cabbage is allowed on his diet. The answer, of course, is “What, you think for a little mountain water I’m gonna keep myself alive?”

Financial risk-taking has come to a similar juncture. Politicians and regulators agree that risk doesn’t belong in banks because it might require another taxpayer bailout. It doesn’t belong in hedge funds either - they are murky and generally wicked. Be sure not to imperil insurance companies or government agencies. And keep risk far away from retail investors, who need protection most of all. Oh yeah, we want risk-taking somewhere so we can have a dynamic economy. It’s our financial stuffed cabbage.

We could simply accept less risk-taking and live with the consequences. Angela Merkel argued last week for tougher rules for financial institutions, acknowledging that they would curtail growth during the boom times but arguing that lower growth is acceptable in exchange for a world with fewer bubbles.

Merkel’s solution would be a sad and unnecessary outcome. We can have simpler banks operating with higher capital ratios and less leverage without sacrificing dynamism. Society has tools at its fingertips that can do the job.

One of them, securitisation, has a battered reputation due to its role in the US mortgage crisis and excesses of structured finance CDOs, and regulators are keen to reign it in. But without any radical regulatory changes or any new institutions, securitisation could help build a resilient financial system in which banks function like utilities: banks can take deposits, originate and service loans to their clients, then ship the risk off to end investors. It is these investors, such as hedge funds or sovereign wealth funds - whose profits and losses will be a concern to themselves and not the public - who bear the risk.

Let’s consider an example: Europe’s small and medium size enterprises (SMEs). These family businesses obtain loans or working capital facilities via their relationship banks. They are too small to tap the capital markets directly. They do not want to issue shares that will dilute the family’s control or complicate corporate governance.

For more than a decade, SME securitisation has helped European banks simplify their balance sheets and free up credit lines to make loans to these companies. Currently, 70 publicly rated European SME transactions are outstanding. They shift the risk of 400,000 SME loans in Germany, Spain, Belgium, the Netherlands, Portugal and the UK Taken together, they save the banks about €15bn in Tier 1 capital - about half of one Deutsche Bank. The figures do not even include the private, bilateral market which may be as large again as the public.

During the financial crisis, some investors in SME securitisations lost money, particularly those who bought deals from Spain. But that is how it is supposed to work. Spanish banks received compensation to offset the losses in their lending books.

European SME securitisations are largely synthetic, meaning the credit risk is transferred to a special purpose vehicle through a credit default swap. (This is a clear example of vilified devices serving purposes of good.) The loans remain on the banks’ books, so securitisation will not disrupt longstanding relationships between the banks and their clients.

To preserve and expand the benefits of securitisation, regulators need to abide by four dos and don’ts:

1) Do prohibit banks and their affiliates from buying the securitisations of other banks. This opens up endless possibilities to game the capital rules. For the past nine months, banks and proprietary trading desks of investment banks have banded together to issue callable structures to one another. These deals are virtually risk free for both sides, yet they succeed in reducing the issuers’ risk weighted assets. Securitisations belong with end-investors.

2) Do give banks credit for assets that have been securitised, especially when imposing limits on gross leverage, even if those assets remain in the banks’ financial statements.

3) Don’t force issuers to retain a portion of the assets they securitise. Such a primitive attempt to achieve alignment of interests won’t work, because banks are not one person, and it is a mistake to anthropomorphise them. Just because one part of a bank owns a sliver of risk will not affect how a lending officer in another part services the loan, or what diligence a workout officer will apply when seeking to maximise recoveries.

4) Don’t implement rules to increase transparency. The marketplace will demand and get the transparency it requires. Banks have every incentive to balance the information they release with the extra comfort it gives investors. Regulation will result in less efficient structures which will translate into less securitisation and ultimately less lending.

We must not give up on the prospect of safe banks and a financial system that will foster a dynamic economy. With only a little help from regulators, banks with higher capital requirements will naturally choose to securitize. European SME securitisation, alone, could grow to five times it current size. Investors - not taxpayers - will be rewarded (or not) for the risks they knowingly accept.

The author is chief executive officer of investment management firm Christofferson, Robb & Co. and professor at Columbia’s School of International and Public Affairs

July 9, 2009 7:07pm in Central banks, Recession, Regulation | Comment