NY Fed report finds large post crisis regulation impacts on bank intermediated arbitrage

Researchers from the NY Fed argued in a staff report that post-crisis bank regulation can explain large, persistent deviations from parity on basis trades requiring leverage. Documenting the financing cost and balance sheet impact on a broad array of basis trades for regulated institutions, researchers show that the implied return on equity on such trades is considerably lower under post-crisis regulation. In addition, although hedge funds would serve as natural alternative arbitrageurs, the report documents that funds reliant on leverage from a global systemically important bank suffer significant declines in assets and returns relative to unlevered funds.

Thus, post-crisis regulation not only affects the targeted banks directly but also spills over to unregulated firms that rely on bank intermediation for their arbitrage strategies. Researchers do not argue that the post-crisis regulatory changes themselves are the cause of deviations from parity. Instead, when exogenous factors move the basis spreads away from zero, regulatory requirements disincentivize market participants from entering into trades that would counteract the effects of such exogenous shocks. When such shocks do occur, they reveal the changed economics of spread-decreasing positions.

Read the full report

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