One of our readers pointed me to a paper by Edward Kane with the unfortunately complicated title “Extracting Nontransparent Safety Net Subsidies by Strategically Expanding and Contracting a Financial Institution’s Accounting Balance Sheet.” The paper is an extended discussion of regulatory arbitrage — not the specific techniques (such as securitization with various kinds of recourse) that banks use to finesse capital requirements, but the larger game played by banks and their regulators. This is how Kane frames the situation:
“Regulation is best understood as a dynamic game of action and response, in which either regulators or regulatees may make a move at any time. In this game, regulatees tend to make more moves than regulators do. Moreover, regulatee moves tend to be faster and less predictable, and to have less-transparent consequences than those that regulators make.
“Thirty years ago, regulatory arbitrage focused on circumventing restrictions on deposit interest rates; bank locations; charter powers; and deposit institutions’ ability to shift risk onto the safety net. Probably because regulatory burdens in the first three areas have largely disappeared, the fourth has become more important than ever. Today, loophole mining by financial organizations of all types focuses on using financial-engineering techniques to exploit defects in government and counterparty supervision.”
Large banks can increase the benefit to them of the government safety net by becoming larger, more complicated (less transparent to regulators), and more politically powerful; yet, as Kane observes, they do not exhibit increasing returns to scale. The implication? “As institutions approach and attain TDFU [too difficult to fail and unwind] or TBDA [too big to adequately discipline] status, value maximization leads them to trade off diseconomies from becoming inefficiently large or complex against the safety net benefits that increments in scale or scope can offer them.” In other words, mega-banks take on the inefficiencies of being complicated, unwieldy, bureaucratic, etc. because they are compensated for by greater safety-net benefits.
In this interpretation, the point of structured finance is not just to reduce capital requirements, but to make it harder for regulators to estimate systemic risk implications and easier for them to ignore what is going on. Unfortunately, regulators do not face incentives that motivate them to take appropriate corrective action. Instead, “history shows that top supervisory officials that respond in a market-mimicking way [that is, the way private creditors would respond] to these signals [of financial deterioration] at TDFU firms must expect to be pilloried rather than praised both in congressional hearings and in the press.” Instead, Kane proposes that heads of regulatory agencies be paid in part through deferred compensation that would potentially be forfeited based on the performance of the institutions they supervised during the subsequent years, including the years after they left office.
One conclusion we can draw is that the bigger and more complex a bank, the harder it will be for regulators to adequately monitor what is going on, and this is one reason that banks make themselves big and complex (it doesn’t just happen by itself). This seems important to bear in mind in assessing the likelihood that current regulatory reform proposals will do the job they are supposed to do.
By James Kwak