Regulatory arbitrage

Editor's letter

Arbitrage is part of the lifeblood of the international capital markets. By hunting down discrepancies in the pricing of equities, currencies and other financial instruments, traders supposedly provide the benefits of liquidity and easier price discovery for longer-term investors.

Companies and financial institutions are also not averse to a bit of arbitrage when it suits them. Here the source of price discrepancy is a regulation or rule that determines a particular capital structure or cost in a particular legal jurisdiction. If a company perceives a discrepancy between two jurisdictions in which it does business, it can do a number of things. It can go 'regulator shopping', finding the friendliest regime in which to do business and optimising its structure accordingly. Or, it can deploy capital markets tools to obtain an economic or competitive benefit from the discrepancy.

Regulators, and tax authorities, try to identify these techniques and eliminate them.

A classic example comes from banking regulation. In the late 1980s, bank regulators came up with 'Basel I', a capital framework that required banks to hold a fixed percentage of capital against outstanding loans. In the 1990s, banks developed 'economic capital' that incorporated the risk of default, and was often wildly at odds with regulatory requirements.

Sophisticated banks then set up securitisation programmes to sell the least risky loans (which tied up regulatory capital) and keep the riskier ones. Spotting this, banking regulators introduced Basel II, which aligns regulatory capital far more closely with economic capital.

It is probably too early to say whether Europe's Solvency II process will deliver the same kind of evolution for insurers. However, with the growing use of economic-based or market-based valuation, insurers are becoming increasingly aware of the deadweight effect of outdated regulatory capital requirements, and are making noises about it.

Witness the recent complaints being made to the UK's Financial Services Authority about what many see as an over-prudent interpretation of current EU directives in the Peak I statutory regime. The growing public presence of the CRO Forum is another sign of impatience.

But it is worth remembering that if insurance securitisation was at a more developed stage, insurers might give up on lobbying and simply follow the regulatory capital arbitrage path taken by banks. By contrast, arbitrage seems to be alive and well in the pensions world.

Witness the differing actions being taken by corporate pension sponsors in the UK and Germany. In the UK, FRS17 valuation is finally becoming mandatory, and there is no escape. The result is a series of enormous revaluations, deficit reductions, and on occasion, substantial share price movements.

In Germany the situation is far more placid. True, some German companies have been making large payments of cash into newly established contractual trust arrangements (CTAs), but there the resemblance to the UK ends. A phenomenon that puzzles some observers, CTAs are entirely voluntary off-balance sheet vehicles that ringfence pension assets against liabilities.

A possible motivation for CTAs is arbitrage - of credit ratings agencies and IAS19 accounting rules - which both only recognise pension liabilities when they are on-balance sheet.

Another form of pensions arbitrage is being mooted in the UK, where investment banks, private equity groups and hedge funds are considering entering the growing market in pension buyouts. The incumbent providers in this market are insurers that charge for buyouts on the basis of being required to hold regulatory capital by the FSA.

Some of the new entrants are said to be negotiating with the UK Pensions Regulator in order to sidestep the FSA completely. If this happens, it will be an embarrassment for the FSA and will raise eyebrows abroad, where the split between UK life and pensions regulation has been criticised. In the world of life and pensions, arbitrage seems to be alive and well.

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