Wonder why the US Dollar is so strong against the Euro lately? The European banks were apparently using AIG to get past capital reserve requirements… and with AIG being knocked out of the game, a lot of problems start piling up quickly…

The K-10 annex of AIG?s last annual report reveals that AIG had written coverage for over US$ 300 billion of credit insurance for European banks. The comment by AIG itself on these positions is: ??. for the purpose of providing them with regulatory capital relief rather than risk mitigation in exchange for a minimum guaranteed fee?. AIG thus helped to organise regulatory arbitrage on a gigantic scale. A formal default of AIG would have had a devastating impact on banks in Europe. This explains why AIG?s problems had sent shock waves through the share prices of European banks. For the time being the US Treasury has saved, inter alia, the European banking system, but given that AIG is to be liquidated European banks now have to scramble to find other ways of obtaining the ?regulatory capital relief? they appear to need urgently.

Get all that? It’s less well known than it should be, but Europeans banks have long been gaming their regulators, having far less than the actual capital reserves that they needed given their balance sheets. AIG filled the hole, selling credit defaults swaps to European banks via which they could tell regulators that they were adequately covered — at triple-A, no less — while carrying less cash than required.

From Kedrosky.