The Dialectics of Bank Capital: Regulation and Regulatory Capital Arbitrage

This article outlines the reasons that banks and other financial institutions engage in regulatory capital arbitrage and the techniques they use to do so. Regulatory capital arbitrage describes transactions and structures that firms use to lower the effective regulatory “tax rate” of regulatory capital requirements. To the extent that these 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. Financial institutions employ a range of complex transactions and structures, including securitization, to engage in regulatory capital arbitrage. The article briefly sketches how capital regulations and regulatory capital arbitrage have evolved in dialectical fashion. This article concludes by describing and evaluating two broad approaches to dealing with the dynamic and unstable nature of capital rules (i.e. their constant erosion by regulatory capital arbitrage): simple, broad brush rules (such as simple and large increases in regulatory capital levels) and more regulatory engineering that attempts to keep pace with the increasing complexity of financial institution balance sheets and transactions