Regulatory Capital Arbitrage for Beginners

For a complete list of Beginners articles, see Financial Crisis for Beginners.

Arnold Kling helpfully pointed out a 2000 paper on regulatory capital arbitrage by David Jones, an economist at the Fed. In his post, Kling said, “In retrospect, this is a bit like watching a movie in which a jailer becomes sympathetic to a prisoner, when we know that the prisoner is eventually going to escape and go on a crime spree.” Having finally read the paper, I have little to add in the way of analysis. But I thought it provided a useful basis for a discussion of what regulatory capital arbitrage (RCA) is and why it is a helpful way of thinking about the financial crisis.

Regulatory capital refers to the amount of capital a financial institution must hold because of regulatory requirements. Capital is the amount of value in a bank that is attributable to the shareholders – that is, the bank’s assets minus its liabilities. There are different kinds of capital, but we can ignore that here.

One function of capital – the function that regulators care about – is to insulate banks from losses. Assets can fluctuate in value; a borrower can owe you $100, but if he goes bankrupt and flees the country, that loan is worth zero. The amount of your liabilities does not fluctuate, however. If you have $100 in assets, $90 in liabilities, and $10 in capital, then you can withstand a 10% fall in the value of your assets and still pay off your debts; if you have $98 in liabilities and $2 in capital, then a 3% fall will make you insolvent (unable to pay off your debts). 

Regulators impose capital requirements in order to help ensure the safety and soundness of banks. There are various reasons why safe and sound banks are good, but the most direct – from the regulator’s perspective – is that the government is insuring the bank’s liabilities; for example, the FDIC now insures deposits up to $250,000 per person. Since the government is on the hook if the bank becomes insolvent, it wants to reduce the chances of that happening – hence capital requirements.

The question is how much capital should be required, and the key concept is risk-based capital. The idea is that some assets are riskier than others. If you hold very safe assets, like cash or short-term U.S. Treasury bills, then the chances of even a 3% fall in value are miniscule, so you shouldn’t need to hold much capital. However, if you hold risky assets, like loans to build offshore drilling platforms in the Arctic Ocean, then you should have to hold more capital. 

The theory is simple. Every asset has a certain amount of risk; a firm that holds that asset should also hold, for that asset, an amount of capital proportional to its risk. Both on the firm level and on the system level, then, capital levels will adequately insure against the risk of losses. The tricky thing is putting this into practice, for two reasons: first, it’s impossible a priori to know how risky a given asset is (you can only estimate it); second, the potential complexity of financial transactions far exceeds the ability of regulators to specify rules for every one. 

The 1988 Basel Accord (now known as Basel I) introduced international standards for risk-based capital requirements. Under Basel I, banks have to hold capital equivalent to 8% of their risk-weighted assets. Each type of asset has a risk weight that reflects its riskiness. For example, OECD government bonds have a zero risk weight – theoretically, they have zero risk, and hence require zero capital; home mortgages have a 50% risk weight; and uncollateralized commercial loans have a 100% risk weight. So if a bank held $100 in Treasuries, $100 in home mortgages, and $100 in commercial loans, it would have $300 in assets, but only $150 in risk-weighted assets (0% * $100 + 50% * $100 + 100% * $100); therefore would have to hold $12 in capital (8% * $150). Looked at another way, the capital requirements are 0% on government bonds, 4% on home mortgages, and 8% on commercial loans.

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.)

How does regulatory capital arbitrage work? There are many strategies, but the most straightforward to describe and to implement is securitization. Recall our bank earlier that had $100 in mortgages, for which it had to hold $4 in capital. Let’s say it creates a simple collateralized debt obligation out of these mortgages. It sells them to a special-purpose vehicle (SPV) that issues bonds to investors; these bonds are backed by the cash flows from the monthly mortgage payments. The bonds are divided into a set of tranches ordered by seniority (priority), so the incoming cash flows first pay off the most senior tranche, then the next most senior tranche, and so on. If these are high-quality mortgages, all the credit risk (at least according to the rating agencies) can be concentrated in the bottom few tranches (because it’s unlikely that more than a few percent of borrowers will default), so you end up with a few risky bonds and a lot of “very safe” ones.

The magic is that by getting sufficiently high credit ratings for the senior tranches, the bank can lower the risk weights on those assets, thereby lowering the amount of capital it has to hold for those tranches. The risky tranches will require more capital, but it is possible to do the math so that the lower capital requirements on the senior tranches more than outweigh the higher requirements on the junior tranches. So you end up with lower total capital requirements – in some cases, 50% lower – simply through securitization. Jones runs through some examples in his appendix. 

An extension of this strategy is to selectively sell some tranches and hold onto others. In this way, a bank can end up with assets that have a high degree of economic risk but a low risk weight for capital purposes. This is possible because the rules setting capital requirements are lumpy (e.g., all home mortgages have a 4% capital requirement) while there is an infinite range of actual financial assets. Structured finance makes it possible to manufacture securities with various combinations of economic risk and regulatory risk weights, which can then be sold to investors with different preferences.

Why would you want assets that have a high degree of risk but require little capital? In general, high risk means a high expected return. So these assets give you a high expected return on a small amount of capital, which is exactly how you maximize your “shareholder value.” This is also how you maximize your true economic leverage – the ratio between the risk you are taking on and the capital buffer you hold – beyond the leverage that shows up in your accounting statements. And, of course, it’s how you maximize the chances that your bank will blow up if something goes wrong.

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. 

As the business developed earlier this decade, many of the lower-rated tranches ended up going not to regulated banks, but to unregulated hedge funds that were trying to maximize their yields. Even though these hedge funds did not have regulatory capital requirements, these custom-manufactured securities had a similar impact there: they enabled investors to take on a large amount of economic risk using a small amount of capital. As a result, they increased the chances that hedge funds would go bust when the economy turned.

In general, a hedge fund failing is not such a terrible thing; that’s the price investors pay for seeking out higher yields. And I don’t buy the argument that hedge funds need to be regulated just because some of their investors happen to be warm and fuzzy, like teachers’ pension funds. However, individual hedge funds could grow large enough that their failure could have systemic effects. And in aggregate, the “shadow banking system” – unregulated institutions that amass capital from investors and direct it to users of capital via various types of investments – is itself a wholesale form of regulatory capital arbitrage, since this part of the financial system can escape regulatory capital requirements altogether, undermining the basic principle that the system should have sufficient capital to support the risks it takes on.  

Regulatory capital arbitrage complicates the problem of designing a new regulatory structure for the financial sector. First of all, it implies that capital requirements must apply in some form to the shadow banking system as well as the traditional banking system. Otherwise, as Jones noted back in 2000, certain forms of financial intermediation will simply shift from the traditional to the shadow system. In addition, if the problem we want to manage is systemic risk, then focusing solely on institutions with certain types of charters will not be sufficient, especially as the unregulated ones become bigger and more numerous. 

Second, it makes it hard to rely on capital requirements as a safeguard against either individual bank failure or systemic failure. It is probably a fair assumption that whatever rules are written, smart bankers and their lawyers will find ways to unbundle economic risk from regulatory risk weights and thereby take on more risk than they are supposed to. In my opinion, this is another argument for imposing size caps on financial institutions to ensure that they do not become too big to fail. 

Third, however, regulatory capital arbitrage also makes it harder to enforce size caps. Let’s say no institution is allowed to have more than $300 billion in risk-weighted assets. What’s to stop it from amassing $300 billion of assets that are disproportionately risky relative to their risk weights? In short, we need a system for risk weighting that is harder to “game” than the current one – and a set of regulators who will enforce it. Given how long Basel II has been going on, and what it has come up with, this is asking for a lot. 

By James Kwak

21 responses to “Regulatory Capital Arbitrage for Beginners

  1. “Regulatory capital arbitrage happens because, all other things being equal, banks would like to hold less rather than more capital.”

    That statement sounds too general to me. Suppose that there were no regulation at all. Would banks then like to hold zero capital? Only if they were con artists, eh?

    “How does regulatory capital arbitrage work? There are many strategies, but the most straightforward to describe and to implement is securitization….

    “The magic is that by getting sufficiently high credit ratings for the senior tranches, the bank can lower the risk weights on those assets, thereby lowering the amount of capital it has to hold for those tranches.”

    I take it that you mean magic as in smoke and mirrors.

    In all this I kept asking, where is a the reduction of risk? All that I found was where you might get somebody else to buy your risk. Finally I went to the site with Jones’s paper. In the abstract Jones says, “In recent years, securitization and other financial innovations have provided unprecedented opportunities for banks to reduce substantially their regulatory capital requirements with ***little or no corresponding reduction in their overall economic risks – a process termed “regulatory capital arbitrage”***.” (Emphasis mine.)

    Just as I thought.

    “It is probably a fair assumption that whatever rules are written, smart bankers and their lawyers will find ways to unbundle economic risk from regulatory risk weights and thereby take on more risk than they are supposed to.”

    Clever, perhaps, but smart? Really?

    “In short, we need a system for risk weighting that is harder to “game” than the current one – and a set of regulators who will enforce it.”

    I think that new financial instruments should be treated like designer drugs. They should be regulated as soon as they are created. Furthermore, the burden should be on the creators to show their safety and value. In this case, it appears that the regulators were aware that securitization was being used to get around capital requirements. Whether they would have OKed it is another question.

    A few weeks ago I saw Obama on TV, talking to a small group of people and a local banker. To my surprise, he explained securitization, and said that it was a good thing. I assume that that is what his advisors told him. That gives me a sinking feeling.

  2. It’s simply false to define the “shadow banking system” as “unregulated institutions that amass capital from investors and direct it to users of capital via various types of investments.” The shadow banking system is comprised of institutions that engage in financial intermediation, but which are not commercial banks.

    To suggest that all institutions in the shadow banking system are “unregulated” is utterly absurd. Money market mutual funds, for example, are part of the shadow banking system, and they are most certainly NOT unregulated. Broker-dealers are heavily regulated under the 1934 Act. Insurance companies are also part of the shadow banking system, but they are regulated heavily at the state level. As dime-store pundits frequently point out in their attempts to demonize CDS, insurance companies have long been subject to capital requirements (which, pundits claim, CDS were supposedly designed to circumvent).

    Not surprisingly, then, Kwak’s claim that the shadow banking system is “itself a wholesale form of regulatory capital arbitrage” is equally as ridiculous. (This essentially amounts to saying that any intermediation that takes place outside the commercial banking system is regulatory capital arbitrage, which, as a securities lawyer, I find particularly comical.) Of course, many, if not most, of the major players in the shadow banking system are also subject to regulatory capital requirements, which in some areas are stricter than the regulatory capital requirements faced by traditional commercial banks, and in other areas are not.

    In any event, Kwak does his readers a serious disservice by suggesting that the so-called shadow banking system — which we used to call “the capital markets” — is (a) unregulated, and (b) a wholesale form of regulatory capital arbitrage. Both claims are flagrantly untrue, and betray a fundamental misunderstanding of the U.S. financial system. Perhaps Kwak can get someone to write a “U.S. Financial System for Beginners” post for him.

  3. The shadow banking system is a term coined by Paul Mcculley here: http://www.pimco.com/LeftNav/Featured+Market+Commentary/FF/2007/GCBF+August-+September+2007.htm

    He states: “the “shadow banking system” – the whole alphabet soup of levered up non-bank investment conduits, vehicles, and structures.”

    By this definition money market funds, insurance companies and hedge funds interact with the shadow banking system, but are not in fact part of it. The usage in this post is, I believe, consistent with this definition.

  4. So a securitised pool of loans could be set up so the sum of the VAR’s of all the tranches would be up to 50% less than the sum of the VAR’s of the individual loans? With a consequentially lower capital requirement and hence higher available leverage?

    And then presumably the lower tranches could be further sliced and diced to give similar, but smaller, second and higher order effects.

    I had not considered this aspect of securitisation before, or even seen it emphasised.

    Fascinating.

  5. Counterpointer

    James – a practical example or several would help, such as European institutions gaming their regulator by booking dubious AIG CDSs as Tier One capital and thereby complying with at least the letter of Basel II, if not the spirit, intent, numbers, inherent catastrophic risk etc.

    As I understand it, ie minimally, Basel II VaR was also methodologically flawed by taking a very short historical default / risk data series, and naturally extrapolating it foward. Thus is bubbletime, the model, not only did assume that risk was minimal, and in essence VaR was stable or declining, but that’s the only result possible given the model and time series.

    Problem two, briefly, is even if risk management moved away from the short(est) run historical series to assess future VaR, there’s the everso minor matter of CDS pricing itself being used as a transparent and reliable means to retrofit risk onto the instruments (viz the gaussian cupola formula). That is, because pricing in the market is perfect, then lower prices for CDS tranches is directly correlated to risk. This of course is a logical absurdity, and represents an ideologically-driven reverse causality. One analogy would be your insurance company telling you there will be no hurricanes this year because your premium is low.

    Now, the number of hurricanes checking insurance premia before deciding to beef up to force 5 or make landfall is not well documented but I suspect it is around zero.

    C

  6. patent.drafter

    Regarding the problem of a priori risk, a guy named Joel Jameson (who specializes in justifying ESOP and executive stock compensation programs) has some intriguing (and, in view of recent events, quite accurate) ideas on the difference between “objective” and “subjective” probability paradigms.

    Regarding circumvention of Basel II, a wonderful company named Accenture played a key role in advising Euro banks on how to redefine their asset portfolio risks. To minimize competition in the evasion of government regulations, Accenture sought patent protection in many jurisdictions for their business methods and systems – and in the process, laid a valuable historical paper trail explaining the motivations of our present financial crises.

    Finally, regarding the assertion that (state-regulated) insurance companies do not provide regulatory capital arbitrage … surely, if this assertion were true, insurers would not invest the time of lawyers and accountants to assess the business impacts of state insurance commission rulings. However, “arbitrage” is not the same as “complete evasion”. Rather, arbitrage relates to conscious choice of where and how to operate based on differing rules in different jurisdictions. For example, when TARP funds became available to bank holding companies, investment banks changed their business positions – as did some insurers.

  7. Counterpointer

    patent drafter – have seen this all too many times, where objective is a noun, not an adjective.

    C

  8. If the problem is that the supervisory framework relies on a one-size-fits-all approach to risk when some asset classes require a more sophisticated approach to risk, why not scrap the risk classifications and just have periodic stress tests for the banks based on economic/market realities?

  9. Earendil Star

    Certainly, regulation probably needs to be overhauled, but the real issue here is (1) personal accountability and (2) separation between regulators and regulated entities.
    (Non-)systemic risk can only be reduced if top managers are certain of having to face dire consequences if they act irresponsibly:
    under no circumstances should the top management hope to be bailed out together with the institution, or non-eligible institutions hope to be bailed out.
    Salaries and bonuses should be repaid if it turns out they were coming out of from fake profits.

    Morale: even the most perfectly devised regulatory framework will fail if there is no certainty it will be upheld during a crisis.

    Sadly, the institutional response so far gives no reason to believe this will be happening any time soon, if ever.

    And it was this failure, the belief by top managers of remaining unscathed whatever happened, that really brought us to the current mess.

  10. To amplify Min’s point in the first Comment, it is probably unfair to deem this regulatory arbitrage. Banks generally hold 50% to 100% MORE in capital than is required by regulation. The reason for this, supposedly, is to garner high enough ratings from the rating agencies that they can play as derivatives counterparties (less than an A rating and you get hammered with extra margin). So the binding constraint is usually rating agency requirements, not regulator requirements.

    Of course, it is possible that the rating agencies, despite their supposed fancy modeling, really just require banks to hold 50% more than what the regulator wants. If that’s true than regulatory capital arbitrage really is the game that banks need to play. But that’s just abdication on the part of the rating agencies, and they’d never admit it.

  11. The “shadow banking system” does not refer to any institution that provides intermediation that is not a commercial bank. By your definition, a lot of ridiculous institutions would be part of the shadow banking system.

  12. My comment was directed at Sandy, not CCM.

  13. Honest, your honor, my clients are honorable people and did nothing wrong in any way. The system is just fine the way it is.

    The mouthpiece speaks.

  14. What you are saying does not actually contradict Jones’ argument, which is that through regulatory capital arbitrage banks are able to achieve effective capital requirements that are below the nominal capital requirements because they model risk differently than the one-size-fits-all approach to risk used in banking regulations. They can meet or exceed nominal capital requirements while carrying a lot more risk.

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  16. I’m halfway through Gillian Tett’s new book, _Fool’s Gold_, about the development of the credit derivatives market. It has a few good anecdotes about how different financial institutions chose to (or, in the case of pre-Chase merger J.P. Morgan, chose not to) use the new instruments to play shell games with regulatory capital requirements.

  17. I believe that any practice which leads to unregulated arbitrage is inherently risky. And, when regulation is achieved, all potential leaks must be plugged, probably by having the regulator (should be an “uber” regulator which can regulate all affiliated markets where risk shifting can occur) be given the right and responsibility for approving any and all activities of the potential arbitrageurs, including any new instrument or methodology. It is hateful to have to do this, but since Greenspan’s surprise that markets ARE NOT NATURALLY MOTIVATED BY SELF PRESERVATION (except as to their lobbyists), it appears to be necessary. If this cannot be effectively legislated, the market place will continue to be volatile de facto, and Congress’s failure to regulate will result in a new group of Congressmen being seated. The present Congress is not far from being booted out, and the failure of the present “recovery” is likely to ensure lots of future risk for our legislators. There can be healthy arbitrage, but only at the fringes, not in the core of what should be a conservatively managed financial banking system.

  18. There is no question that the rating agencies should be required to be transparent, and not be paid by the parties desirous of appropriate ratings. We’re talking serious rating agency regulation. (Obviously there is a good reason why the rating agencies have the highest profit margins — easy to make money be having one guy at a desk with a small set of rubber stamps.)

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  20. Yes, it does. The “shadow banking system” is widely understood to mean nonbank (i.e., nondepository) financial institutions engaged in financial intermediation.

    For example, here’s Paul Krugman’s description of the shadow banking system:

    “[T]he old world of banking, in which institutions housed in big marble buildings accepted deposits and lent the money out to long-term clients, has largely vanished, replaced by what is widely called the ‘shadow banking system.’ Depository banks, the guys in the marble buildings, now play only a minor role in channeling funds from savers to borrowers; most of the business of finance is carried out through complex deals arranged by ‘nondepository’ institutions, institutions like the late lamented Bear Stearns — and Lehman.” (http://www.nytimes.com/2008/09/15/opinion/15krugman.html)

    And here’s Nouriel Roubini’s definition:

    “Last week saw the demise of the shadow banking system that has been created over the past 20 years. Because of a greater regulation of banks, most financial intermediation in the past two decades has grown within this shadow system whose members are broker-dealers, hedge funds, private equity groups, structured investment vehicles and conduits, money market funds and non-bank mortgage lenders.” (http://www.ft.com/cms/s/0/622acc9e-87f1-11dd-b114-0000779fd18c.html)

    Before the sexier-sounding “shadow banking system” title came along, we used to talk about the bank-based financial system versus the capital markets-based financial system. Remember the whole debate about “disintermediation”?

    It’s not that the shadow banking system is “unregulated” — a completely meaningless political term in any event. It’s that the shadow banking system doesn’t have FDIC deposit insurance (or its equivalent), which makes it susceptible to classic bank runs. The implosion of the ABCP market, as well as the massive electronic run on money market mutual funds after the Reserve Primary Fund broke the buck, illustrate the dichotomy.

  21. CCM and Bond Girl — My reply showed up down below for some reason.