Frances Coppola on regulatory arbitrage

Frances Coppola recently wrote an interesting article on the origins of the financial crisis, which reflects several of the points that I have made on this blog time and time again: the crisis is the resulting product of the combination of regulatory arbitrage and interest rates below their natural level (as well as a few other things). I encourage you to read her article (which is at least necessary to follow my own post).

Yet I believe her story isn’t fully accurate. While US banks were subject to a leverage ratio, they were also subject to Basel 1 rules. As I have demonstrated, Basel 1 caused a surge in real estate and sovereign lending, and boosted the use of securitization, through regulatory arbitrage as Basel applied low risk-weights to those asset classes (for the most recent evidence, see here). Unlike what Hyun Song Shin believes, banks were already circumventing the ‘spirit’ of Basel 1 as soon as it was published in 1988… Basel 2 didn’t change much, and its implementation in Europe was anyway too late to have much of an influence on the crisis storyline (which had been building up since the late 1980s).

As a result, I don’t believe that, if European banks had been subject to a leverage ratio, they would not have been able to invest in American securitized products. They would still have done it, and perhaps sacrificed other type of lending or investments in other securities instead. Why? Because RMBSs and other CDOs offered higher yields for lower capital requirements, ceteris paribus. Risk-adjusted profit-maximising banks quickly figure it out.

She concludes:

The story of the financial crisis is a story of the failure of safe assets. That is why it was so traumatic. People expect to take losses on risky investments. They don’t expect to take losses on safe ones. Yet we are still trying to make the financial system “safer” and encourage investors to invest in “safe” assets. When will we learn that the safest investment is a risky one, and the most dangerous investments are those that are believed to be completely safe?

And it is also a warning of the consequences of regulatory arbitrage. The fact that the US and European banks had different regulatory regimes created a golden opportunity for unregulated institutions to exploit, with catastrophic consequences. Yet the US, the UK and the EU are still devising their own systems of regulation with scant regard for international consistency. When will we learn that an international industry requires international regulation?

I would say that the crisis wasn’t a failure of safe assets per se. It was a failure of regulation that wanted us (or actually, forced us) to believe that some assets were safe, creating a vicious spiral as banks piled into those asset classes to maximise their return on regulatory capital.

Moreover, regulatory arbitrage isn’t a cross-border issue. Most countries experienced the same symptoms: increasing real estate prices and securitization-issuance volumes, and lower sovereign debt yields. This points to intra-Basel distortions within countries, not to extra-Basel arbitrage across countries. Regulatory arbitrage-driven financial imbalances are endogenous to Basel regulations. Cross-border arbitrage, the Euro, populist politics (which never dies, as US politicians – incredibly – want to revive Fannie and Freddie…), also played a secondary (and surely exacerbating) role, but they were not at the very root of the crisis.

PS: Frances just published a new article on the ECB stress tests. I don’t disagree with her, but I believe that it is easy to criticise the test in hindsight, once we found out the number of banks that failed: she could have attacked the methodology at the time it was published. She also missed that, if banks don’t increase lending post-result announcements, it isn’t necessarily because they are zombies (some may well be). But the test was run on phased-in Basel 3 CET1 figures, not fully-loaded ones. Many banks still have large capital adjustments/deleveraging to make before complying with fully-loaded Basel 3 requirements, which isn’t going to help lending growth, especially given that banks currently don’t cover their cost of capital. (Another inconsistency of the test is that some banks were tested against fully-loaded ratios, and in the end obviously appeared uglier than if they had been tested against the same standards as other banks. If all banks had been tested against fully-loaded capital ratios, 36 would have failed)