Question

Regulatory Arbitrage Assume you are the CEO of a bank and feel that the risk regulations are too constraining. What are ways you could use to take more risk while still respecting the regulation:

1. Under Basel I 2. Under Basel II

Answer 1

Ans 1) Under Basel 1: Regulatory capital arbitrage happens because, all other things being equal, banks would like to hold less rather than more capital. The reason is that, in general, bank profits are proportional to the amount of assets that they hold. One main source of banking profits is interest margin: the spread between the interest charged on loans and the interest paid on deposits and other sources of funding. For any given interest margin, profits will be strictly proportional to loan volume (assets). The same logic applies to banks’ principal investment and trading businesses; for any given strategy, doubling the size of the position will double the expected profit. So to increase profits, you have to increase assets. If a bank wants to increase its assets, it can do so either by increasing its leverage (lowering its capital as a percentage of assets) or increasing its capital; the former is preferable, because the latter requires issuing new shares, which dilutes current shareholders. (Also, issuing new shares results in lower earnings per share, lowering the stock price.)

There are many strategies, but the most straightforward to describe and to implement is securitization.

Under Basel II: The shift from fixed-percentage capital requirements (Basel I) to value-at-risk(VaR) methodologies (Basel II) only increased the potential for regulatory arbitrage. In VaR, the riskiness of any asset is determined by a model based on the historical attributes of the asset. In theory, this is an improvement, because it gets around the problem of lumpy fixed percentages, and tailors the risk weight to the unique characteristics of the asset itself. In practice, however, it made it possible to assess riskiness based on small amounts of historical data from periods during which, for example, subprime loans rarely defaulted because rising housing prices always made it possible to refinance. By underestimating the risk of certain assets, these models underestimated the capital required to support these assets.