Comments on: Regulatory Capital Arbitrage for Beginners

By: Sandy

Sandy — Wed, 03 Jun 2009 03:31:23 +0000

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

By: Sandy

Sandy — Wed, 03 Jun 2009 02:50:54 +0000

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.

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By: Bayard

Bayard — Mon, 01 Jun 2009 16:07:23 +0000

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.)

By: Bayard

Bayard — Mon, 01 Jun 2009 16:03:25 +0000

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.

By: Marcus

Marcus — Mon, 01 Jun 2009 03:58:28 +0000

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.

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By: Bond Girl

Bond Girl — Sun, 31 May 2009 18:23:14 +0000

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.

By: jrw

jrw — Sun, 31 May 2009 18:19:30 +0000

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.

By: Bond Girl

Bond Girl — Sun, 31 May 2009 18:08:02 +0000

My comment was directed at Sandy, not CCM.

By: Bond Girl

Bond Girl — Sun, 31 May 2009 18:05:49 +0000

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.

By: mort_fin

mort_fin — Sun, 31 May 2009 17:01:21 +0000

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.

By: Earendil Star

Earendil Star — Sun, 31 May 2009 16:50:35 +0000

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.

By: Bond Girl

Bond Girl — Sun, 31 May 2009 15:28:06 +0000

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?

By: Counterpointer

Counterpointer — Sun, 31 May 2009 15:03:15 +0000

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