Arnold Kling  

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One of the themes of their baseline scenario blog is that banking regulators have been captured by large banks.

In researching the history of capital regulation, I came across this paper by David Jones, of the Federal Reserve Board. It was written in 2000, and it describes how securitization and off-balance-sheet entities were used for regulatory capital arbitrage, meaning that it allowed banks to hold the same assets but less capital.

Although academic articles by Federal Reserve Board economists routinely carry a disclaimer that they do not reflect the opinions of the Board or its staff, the article clearly shows that the Fed was aware of regulatory capital arbitrage (RCA)and it paints a largely sympathetic picture of the phenomenon.

Since the underlying securitized assets tend to be of relatively high quality, a strong case can be made that the low capital requirements against these retained risks actually may be appropriate...

Unless these economic and regulatory measures of risk are brought into closer alignment, the underlying factors driving RCA are likely to remain unabated. Without addressing these underlying factors, supervisors may have little practical scope for limiting RCA other than by, in effect, imposing more or less arbitrary restrictions on banks' use of risk unbundling and repackaging technologies, including securitization and credit derivatives.

Such an approach, however, would be counterproductive (and politically unacceptable).

The thinking was that the Basel capital accords required banks to hold too much capital for mortgages (this was probably true). Accordingly, the article takes a sympathetic view of regulatory arbitrage. In retrospect, this is a bit like watching a movie in which a jailer becomes sympathetic to a prisoner, when we know that the prisoner is eventually going to escape and go on a crime spree.

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COMMENTS (7 to date)
J Cortez writes:

Regulatory systems by their very nature become the methods certain industries use to affect the market to their own ends. With the state power, you can effectively "direct" how the competitors in an industry behave.

If you are Microsoft competitor, you call the FTC to fine them and waste their money. If you're in the chemical industry, you call the EPA on your competitor. You call the FCC if you're in cellphones or broadband.

Also, a cartel of larger competitors in a particular industry can influence the regulating body itself, like the ones for energy or insurance. Why would it be any different in banking? Which under the Fed, is a legalized cartel anyway? Capital requirements for banks should be determined by market forces, not a central plan. That means no Basel and no Fed intervention. There are dozens of offices in D.C. that cover the entire range of the financial sector and they not only missed the current crisis but their ineptness helped cause it.

While the original intent of these bodies might have been for good, what they are in practice is not.

fundamentalist writes:

Interesting post. Thanks!

The cult of regulation should consider whether they want regulators to prevent fraud or to actually run the banks. If they want regulators to run the banks, then they should have the state nationalize the banks and run them. If they think regulators are smarter than CEO's, then by all means, let regulators run the banks.

Steve Roth writes:

The "regulatory arbitrage" argument often sees to devolve to this:

People just game the regulations to their own advantage and to capture regulators, so we should not have regulations.

And Arnold has frequently argued that regulations are always backward-looking, correcting for past gaming but failing to deal with the current games.

Those arguments came to mind when I read this yesterday:

From Bloomberg: William Seidman, Who Led Cleanup of S&L Crisis, Dies

In his memoir [published in 1993], Seidman offered a set of lessons learned. They included, “Instruct regulators to look for the newest fad in the industry and examine it with great care. The next mistake will be a new way to make a loan that will not be repaid.”

The goal, to my mind, should not (necessarily) be less regulation or less government. That's far too simplistic. The goal should be good regulation and good government.

Messy work, but somebody's gotta do it.

James Kwak writes:

Thanks very much for pointing this out. I hope to be able to return the favor.

Milton Recht writes:

Regulatory capital ratios capture firm specific events but do not capture economy wide events. Regulatory arbitrage did not cause the current banking crisis and its complete elimination would not prevent a repeat of the current banking crisis.

Regulatory capital is set by lending and investment categories, such as mortgages, but the computed capital ratio is formulaic, static and does not vary by regional or US economic conditions. Additionally, it is in part dependent on outside ratings by credit rating agencies, especially SEC approved NRSROs, which are lagging indicators of changing riskiness and default rates instead of leading indicators.

Holding $100 million of residential mortgages outright or holding the same dollar amount of securitized residential mortgages does not change the risk the institution faces. The regulators compute regulatory capital by form instead of the substance of the asset, and the institution can free up required capital by modifying the form of its holding and use the extra capital to increase its holdings and concentration in that asset, i.e. engage in regulatory arbitrage. Effectively, the increase risk comes from increased leverage and loss of diversification through an increase in a particular asset concentration.

Additionally, since regulatory capital ratios do not change to reflect changing economic conditions, the regulators require banks to hold the same amount of regulatory capital in growth as in recessionary economic times. We know asset default risk is not constant and changes based upon different regional and US economic conditions, e.g. during periods of higher regional unemployment, regional residential mortgage default rates will increase. Similarly, area home values decline during regional economic downturns and the decline in value increases an area's mortgage default rates.

High unemployment rates along with a substantial decline in home values are the cause of the high mortgage default rates. A lingering, worsening recession was the underlying cause.

There are areas of the US where the decline in home values is 20-50 percent from their highs. In many areas of the US, unemployment is at 25-year highs, if not higher. If banks did not arbitrage from direct holdings of residential mortgages into securitized mortgages, banks would still face substantial write-downs. Residential mortgage defaults would still be higher than usual or expected (by capital set aside) due to substantial home value declines and high unemployment.

Weak US and regional economic conditions and their effects severely affected the value of all residential mortgages and their default rates. It is extremely likely that banks would need to raise capital, face heightened regulatory scrutiny and increased risk of government takeover independent of the form of their mortgage holdings. Even if we had restricted the amount of residential mortgage holdings of any form prior to this economic downturn, the banks would have invested their funds in other earning assets, such as credit cards, commercial loans or commercial real estate. All loans face higher default rates in bad economic times and just about all assets lose value.

What we need is a more sensitive, adjustable capital ratio to future economic conditions. Requiring capital based on sensitivity analysis (stress tests) requires banks to hold more capital than necessary in good times, acts contra-cyclically by restricting lending in good economic times, and lowers the earnings of banks.

Since economic forecasting of turning points in the economy is notoriously poor, market based solutions, such as market valued balance sheets, are probably the best but they are not fool proof. Market values of long-term assets, such as mortgages, reflect all expected losses including those several years in the future. The market value accelerates the future expected default into the present. For example, suppose an apartment building has a 20-year balloon mortgage with a constant yearly interest payment. The likelihood of default during the early years of interest payments may be quite low, but the market may have high expectations of default at the end of the twenty years on the final balloon principal payment. The market could easily value the mortgage at 60 to 70 percent of its face value. The discounted value would force the bank to either increase its current capital base or decrease it lending. The bank would feel the effect of the future default now, many years before it would realize the default and be necessary for it to replenish its capital base. Asset based market valuations for long-term assets could affect lending and investment in a counter-cyclical fashion.

One would have to rerun recent banking history under an alternative, proposed regulatory structure and reconstruct a bank's new balance sheet. We could see, based on new, proposed restrictions, prior to going into this recession, if there is anything that would be different now under a different set of rules and if the banking industry could have avoided its current crisis by lending and investing differently.

James Kwak writes:

I should have added - are you writing something on the history of capital regulation? That would be really interesting reading. Well, you know what I mean by "really interesting."

Bob Murphy writes:

In retrospect, this is a bit like watching a movie in which a jailer becomes sympathetic to a prisoner, when we know that the prisoner is eventually going to escape and go on a crime spree.

Except, the crime doesn't occur until the jailer looks at all the bad investments the escaped con makes, and then the jailer robs the whole neighborhood to pay off the bad loans.

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