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Regulatory arbitrage: Let the games begin

Regulatory arbitrage will to take a new form once bankers can get their heads around Basle II.

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.