The Dialectics of Bank Capital: Regulation and Regulatory Capital Arbitrage

Whether banks have enough capital has been one of the most contentious issues of financial regulation in the US and in Europe.  There is a difference, however, between the level of capital required by bank regulation and the effective capital that banks hold after engaging in strategies of ‘regulatory capital arbitrage’. In a 2016 symposium piece, ‘The Dialectics of Bank Capital: Regulation and Regulatory Capital Arbitrage’, I examine regulatory capital arbitrage, including why banks engage in it and several techniques they use for it. Regulatory capital arbitrage describes transactions and structures that financial institutions employ to lower the effective regulatory ‘tax rate’ of regulatory capital requirements. With regulatory capital arbitrage, banks can either take on more risk for a given level of capital – and more than the limits that regulations were designed to impose– or reduce their capital levels while holding risk-taking constant.

Regulatory capital arbitrage is important for at least two reasons. First, regulatory capital arbitrage diminishes the effectiveness of bank capital rules. This is of great concern to the extent that bank capital regulation mitigates the externalities of bank failures on the broader economy. Lower levels of capital and higher levels of leverage leave banks dangerously exposed to economic shocks.  Regulatory capital arbitrage may camouflage this risk, giving the illusion that banks enjoy a capital buffer that can weather a financial storm. Indeed, some economists argue that regulatory capital arbitrage may have exacerbated the severity of the Global Financial Crisis of 2008. Prominent banks that had seemingly sufficient levels of capital nonetheless failed or required government lifelines. The gaming of regulation meant that the effective leverage of these banks and their actual fragility may have been much higher than they appeared, undermining financial stability.

Second, regulatory capital arbitrage helps explain the evolution of bank capital rules. Indeed, bank capital regulation has evolved in an almost lockstep dialectical manner with regulatory capital arbitrage. Each enactment by policymakers of new capital rules has engendered new strategies by financial institutions to game those rules. These new strategies, in turn give birth to a new generation of rules, as policymakers attempt to close loopholes and make bank capital rules more closely match the economic reality of bank balance sheets and risk-taking. Concerns about capital flowing to countries with lighter bank regulation begat the first Basel Accord. Banks exploiting the simplicity of Basel I and taking on more risk on their balance sheet begat Basel II, and its approach of allowing certain large banks to set their own capital according to proprietary risk models. This in turn begat new bank efforts to exploit this internal models approach. And now, post-crisis, we have Basel III.   

My article also explores the impetus for regulatory capital arbitrage. To the extent that capital regulations force financial institutions to internalize the externalities created by their potential insolvency (including systemic risk externalities), the incentives to engage in regulatory capital arbitrage will persist. Government guarantees of financial institutions, explicit or implicit, make debt financing relatively cheaper than equity and further enhance incentives for regulatory capital arbitrage. Restricting government guarantees may be unattractive when that exposes economies to more systemic risk. Regulatory capital arbitrage may thus be a persistent feature of financial regulation.

This Article concludes by describing and evaluating two broad approaches to dealing with the dynamic and unstable nature of capital rules (ie, their constant erosion by regulatory capital arbitrage). The first approach involves simple, broad brush rules. For Anat Admati and Martin Hellwig, this takes the form of much higher capital requirements. Professor Heidi Schooner adds an additional nuance in an article that was the centerpiece of the symposium for which I wrote this article. She argues that policymakers should have a different baseline for capital regulations. Instead of incrementally increasing capital regulations over time, policymakers could have a presumption, anchored in the high finance of the Modigliani-Miller theorem, of high capital levels. Regulators could then allow an individual bank to present evidence that its risk-taking and probability of failure are low enough to justify a lower requirement.

The second approach is to match complexity with complexity. Policymakers could accept regulatory capital arbitrage and the constant evolution of financial institutions, markets, and investments. In response, policymakers can dynamically adjust rules to reflect these realities. That would require, however, that regulators possess the capacities and incentives both to track bank risk-taking and regulatory capital arbitrage and to adjust capital rules in a prompt and appropriate manner.

Erik F. Gerding is a Professor of Law and a Wolf-Nichol Fellow at the University of Colorado Law School.