No “regulatory arbitrage” distorts more than regulators’ dumb and arbitrary risk weighted capital requirements for banks

Sir, Lawrence Summers writes: “The focus of international economic co-operation more generally needs to shift from opportunities for capital to better outcomes for labour. [That] will require substantially enhanced cooperation with respect to what might be thought of the as the dark side of capital mobility — money laundering, regulatory arbitrage, and tax avoidance and evasion.” “Voters sour on traditional economic policy” October 10.

No! The darkest side of capital mobility is how the Basel Committee’s risk weighted capital requirements for banks is distorting the allocation of bank credit to the real economy. Compared to that the damages caused by “money laundering, regulatory arbitrage, and tax avoidance and evasion” are peanuts.

And Summers also holds that “Recessions come intermittently and unpredictably. Containing them generally requires 5 percentage points of rate cutting”

That might apply to normal recessions, but when these have resulted from insane bank regulations, no rate cutting will help in a sustainable way, unless you get rid of the distortions.

It is also amazing to see how experts can lose contact with their inner common sense and, for instance, come to believe that the very risky below BB- rated assets are more dangerous to the banking systems than the AAA rated ones.

By the way there is nothing "traditional" about such regulatory stupidity... it just tracks back to 1988, Basel I.

PS. Here again is an aide memoire that explains some of the regulatory monstrosities.

@PerKurowski ©

Sir, John Kay, while being entirely correct, makes you wonder where he has been the last decade

Sir, John Kay writes “Much of the complexity of modern finance is the result of regulatory arbitrage – avoiding or minimizing restrictions by engaging in transaction with more or less identical effect but more favourable regulatory treatment… Regulatory arbitrage is an inevitable outcome of the detailed prescriptive regulations of financial services” “Arbitrage wastes the talents of finance´s finest minds” August 27.

Of course, Kay is absolutely right, but it makes you wonder where he has been all these years.

Does Kay not know that Basel II, which allowed banks to leverage their equity in the range of 8 to infinite times, made regulatory arbitrage immensely more important for a bank´s return on equity, than being able to allocate credit to the real economy correctly? If, banks had to hold the same capital against all assets, say the Basel II basic 8%, then banks might still be arbitraging, for instance with insurance companies as Kay describes, but regulatory arbitrage would never ever have reached current endemic and monstrous proportions.

And Kay correctly holds that “The better response is to find simpler and more robust principles of regulations? Does he not know that Basel III goes into the opposite direction, increasing the complexity and perhaps even the number of tools in the arbitrage toolbox?

Well clearly Kay has not read the so many letters I have sent him about this issue over the last decade…I guess that happens when you do not belong to a financial columnists intimate network.

That said, I hope that Kay with this recent insight, then would dare start asking the regulators those nasty questions they need to be asked, if our economies are to stand a chance.

If it looks like a distortion, quacks like a distortion, and walks like a distortion then it probably is a distortion.

Sir, Brooke Masters, Tracy Alloway and Shahien Nasiripour report on how banks use “pricey credit default swaps to cut their capital requirements”, “Watchdog to close Basel loophole over use of pricey credit protection” March 25.

And yet these reporters even confronting the willingness of someone to pay “pricey default swaps” cannot seem to understand that must only be because someone has created a distortion, in this particular case that one introduced by Basel regulations which permit banks to hold some assets against less capital than others.

The unhappy Barings’ Bank trader Nick Leeson writes in his memoirs: “And they never dared ask me any basic questions, since they were afraid of looking stupid about not understanding futures and options.”

And how I would like these three reporters to dare ask the regulators for the reason of having capital requirement based on perceived risks which are already cleared for by other means, and, of course, not settling for that fuzzy explanation of “more-risk-more-capital, less-risk-less-capital, does that not sound logical?”

I repeat, our banks are not moved by some invisible hand of the markets, they are moved by the invisible and completely unauthorized and dumb hand of the Basel Committee.

Sir, where have all the daring journalists gone? Worse, where have all the daring editors gone?

Even in very shallow waters one finds regulatory arbitrage

Sir, Gillian Tett in “Baggy surf shorts, ´top freedom´ and the greater cover up” October 29, seems be confessing having engaged in regulatory arbitrage when admitting that she never wore bikini tops in the UK but rarely wore bikinis tops in France”. 

Since Gett, when reporting, seems to be quite happy in general with the rulings of the Basel Committee for Banking Supervision, and this even when those regulations have resulted in serious “malfunctioning”, I wonder whether she might be suggesting we could benefit from a Basel Committee on Beach Dress Code. 

Indeed, that could put some global order on this delicate issue? But also, and from a pure tourism competitiveness point of view, is it really fair that some beaches allow nudity and others do not? I know, I hear you loudly, it depends on the quality of the nudity, but still, could this not be an issue for WTO?

What we need is to pay bonuses for the right kind of risk taking!

Sir the world is definitely confused. Lucian Bebchuk writes “Regulate financial pay to reduce risk-taking” August 4 even though as a Harvard professor he should now that we as a society need risk-taking if we are going to move forward, and so the issue should obviously be more that of regulating financial pay so as to promote the right kind of risk taking.

Also let us stop from hiding the truth. Had the regulators not created the risk arbitrage opportunities derived from the minimum capital requirements and their excessive trust in the credit rating agencies billions of temporary artificial profits would not have been generated and with that there would have been so much money to pay the bonuses to begin with.

Let the government charge for the protection racket services it already provides.

Sir your “Vice of necessity” July 25, where you start hinting at legalizing drugs so as to raise the taxes fighting this crisis needs, opens up our eyes to a lot of unexploited taxing opportunities.

Among these: charging for the protection services already provided to intellectual property right holders; imposing a special tax on government created monopolies and oligopolies such as those of the credit rating agencies; and finally a big special tax on all bonuses derived from capitalizing all those splendid arbitrage opportunities that the financial regulators provide.

Alternatively of course, and like what you seem suggesting, is to get out of protection racket altogether so that much of the illicit and informal economies that most probably are still growing at healthy rates, can join the rest of the economy and be taxed as all of us.

What does not seem logical though is to remain in the wishy-washy middle ground.

FT is at long last very close to getting it, come on just one more push!

Sir about six years and 300 letters of mine later you are finally asking to “cut back the credit rating agencies quasi-public authority” Raters berated, July 23. A bit slow, and thick, but, nonetheless, well done!

Having said that when you refer to the EU’s recent directive on capital ratios I see you are still harbouring some confusion. Let me try to explain it again… letter 301?

The regulators arbitrarily imposed distortions in the financial markets when they decided, for instance, that in order to lend to a non-rated borrower a bank needed 8 percent in equity while for a triple-A rated only 1.6 percent is required. Even if the EU now rules that the banks cannot, no matter what, leverage themselves over some maximum figure, but leave otherwise intact the current structure of minimum capital requirements then, on the margin, all the distortions remain. You see in finance and in so many other things in life it is the marginal decision that counts.

By the way… is a job in a triple-A rated company more worth to defend than a job in a B- company? The regulators in Basel seem to think so.

But Hank had company.

Sir John Gapper in “Too long in the spaceship, Hank” March 5, mentions that AIG´s “biggest money-spinner was regulatory arbitrage”. Exactly!

Before Basel banks and financial institutions always engaged in some regulatory arbitrage but it was mostly harmless. It was when the Basel Committee concocted a system of minimum capital requirements based on what they perceived as risk, and as measured by their risk sentries the credit rating agencies, that the real regulatory arbitrage business took off globally and turned into the extreme systemic danger it has proven itself to be.

And so if a Hank has been too long in a spaceship so has his fellow bank regulators.

But why did the regulators, knowingly, tempt the bankers?

Sir Gillian Tett shows great expertise describing the physical evidences gathered in the ongoing “forensic research” like the regulatory arbitrage that resulted from that the super-senior debt that carried the triple A tag and that only required banks "to post a wafer thin sliver of capital against these assets”, “Super-senior losses just a misplaced bet on carry trade” April 18.

Where Tett falls short though is in the reconstructing of the scene of the crime, since nowhere does she ask herself why the regulators exposed the bankers to these types of temptations, especially when they must have known they would fall for them.

My personal answer is that the regulators were so obsessed with fighting their own demons, “the default risks”, so that they did not care for anything else; and neither did they want or listen to other opinions, since they wanted to show themselves to be independent.

If there is one single lesson that stands out from the current turmoil it is that the regulation of the financial sector cannot be left solely in the hands of the regulators, since single-mindedness is not a good enough reason to award anyone independence.