A halt to the regulatory arbitrage that became rife in the financial services industry following the introduction of Basle I was a key objective when the new Basle II rules were being planned.
It’s fair to say that the securitization, credit derivatives and structured credit businesses would not exist without regulatory capital arbitrage. A vast industry has grown out of repackaging assets and selling them to third parties that are not constricted under Basle rules. The trick is that while the regulatory risk associated with the sale is transferred – freeing up banks’ capacity to continue originating the very same assets – the economic risk is mostly retained. For instance, at the end of each year comes a wave of massive collateralized loan obligations that take place purely to benefit from such arbitrage.
Banking supervisors have understandably grown uncomfortable with this. But is the new Basle regime any better than the old? The goal of actually trying to link regulatory capital with economic returns is in principal a good one, but the new rules are complicated.
Most market attention has been on pillar 1 of Basle II, which is associated with risk measurements. On one side of the capital equation, the regulators have left the minimum regulatory capital ratio requirement unchanged at 8%. On the other side, they have introduced operational risk and dramatically altered how credit risk is measured.
Banks can take three approaches: the standardized approach, an internal ratings-based (foundation) approach and an IRB advanced approach.
Because it is easier to map from Basle I, most interest has been in the impact on buying debt under the standardized approach. Banks and sovereigns that are rated lower than triple A are among those for which lenders’ risk-weighed capital requirements rise. Perversely, the capital charge for a B-rated entity is greater than for an unrated credit, an approach that actually encourages unrated entities. The winners should be lenders to retail and high-quality corporates, as the risk weighting associated with holding these assets on banks’ balance sheets drops substantially.
Despite the fact that under the standardized approach most banks require substantially less capital – as much as 20% less for Nordic banks according to Credit Suisse – the regulators are not allowing capital to leak out of the financial system.
Why? Regulators are known for their caution. It is understandable that they would want to wait a few years before they sanction any significant reduction.
Perhaps they want to see how successful banks are at finding new ways of conducting regulatory arbitrage. Because the outcomes under the IRB approaches differ substantially from those under the standard approach, already some of the more canny observers believe there is scope for banks operating under one of the different approaches – say, foundation versus IRB advanced – to flip assets to another operating under a different one. The old game might have ended, but a new game is about to begin.
