Regulatory arbitrage: a crime, or a warning?

It could be unwise to ignore disproportionate regulatory impacts on specific business lines

On both sides of the Atlantic, the net is closing in. The US intermediate holding company (IHC) rules forced foreign banking organisations to comply with tougher local regulations. So some foreign banks tried to escape by moving activity into branches that are still subject to home-country rules.

But now, in the European Union, lawmakers are looking to close one of the loopholes that make EU rules softer than those in the US. Instead of complying with the leverage ratio once a quarter on the reporting date, banks will have to comply on average across each quarter.

If you see all regulatory arbitrage as a trick to boost profits at the cost of weaker financial stability, then less arbitrage opportunity is a cause for celebration. But it is interesting to note that, in their efforts to evade the leverage ratio – and, in the case of IHCs, the US stress-testing regime – banks have tended to focus only on certain business lines.

Top of that list is repo trading. It’s known as a low-risk, low-margin activity, mostly backed by government bonds to which regulators themselves grant a zero risk weight in many cases. Pile capital onto the business, and the numbers don’t add up.

If these business lines matter – and government bond repo certainly matters for national treasuries and central bank monetary policy transmission – squeezing margins until they disappear might not be a smart move. In that case, regulatory arbitrage should not be condemned unreservedly. The real question should be: are banks actually trying to find a way to keep this business alive? If that’s the case, then ignoring warnings from the banking sector could drive activities onto less regulated non-bank counterparties.

The impact of the leverage ratio on low-risk, low-return assets has been known for a long time. The justifications for an insensitive measure are clear enough. Risk-based capital depends on models that can be unreliable or subject to gaming – though more rigorous supervision might be a less blunt instrument than the leverage ratio to solve that problem. But even assuming models are accurate, a low-risk business transacted in huge volumes can turn into a systemic risk, because any tail event can trigger large, widespread losses.

This second argument is a compelling one. Regulators cannot really be expected to ignore a vast repo desk simply because it poses low risks most of the time. Since 2008, ‘most of the time’ isn’t good enough.

How should regulators draw the line between closing up the loopholes, and closing down a business? The answer is hard data. The Basel Committee on Banking Supervision observed when it published its January 2016 Basel III market risk rules that quantitative impact studies (QIS) for the earlier Basel 2.5 – devised in the immediate aftermath of the crisis – had exaggerated the actual capital impact. It’s no surprise banks might talk up the damage of new rules in a bid to soften their calibration.

But that’s no reason for complacency or condescension from regulators. Basel has now been forced to reopen the market risk rules after recognising the impact on specific assets had been excessive. The Financial Stability Board is already examining the effects of prudential regulation on infrastructure finance and on the uptake of central clearing. Perhaps it is time to add repo trading to that list.