Two attempts to reduce regulatory arbitrage, for good or bad (Finadium subscribers only)

Last week we saw notices of two attempts by regulators to reduce arbitrage in global banking rules, for better or worse. The first came from the Basel Committee on Banking Supervision in a discussion of Credit Default Swaps. The second from a Reuters report that European banks were meeting with Federal Reserve Governor Daniel Tarullo in an effort to divert planned capital rules for foreign banks in the US. These are difficult issues to solve, as they are affected and in turn affect multiple factors in financial markets.

The Basel Committee report, “Recognising the cost of credit protection purchased,” dealt primarily with how banks account for CDS in their risk capital calculations. However, the Committee commented directly on capital arbitrage, whereby a bank would hold a CDS for the express purpose of reducing their risk-weighted assets (RWA) or other Basel III risk capital ratio. According to the document:

“There exists potential for capital arbitrage within the credit risk mitigation framework, including use of credit risk mitigation for securitisation exposures, particularly when (i) there is a delay in recognising the cost of protection in earnings while (ii) the bank receives an immediate regulatory capital benefit in the form of a lower risk weight on an exposure on which it is nominally transferring risk. In such instances, there may be no meaningful transfer of risk. For example, consider a bank that purchases credit protection on a first-loss retained securitisation position where the cost of protection is equal to the recorded value of the securitisation tranche on which protection is being purchased or where the terms and conditions of the contract ensure that the premiums paid throughout the life of the contract will equal the amount of the realised losses. Regulatory capital arbitrage may exist where the immediate capital relief recognised for credit protection purchased ultimately will be offset by the premiums paid and recognised in earnings over the life of the contract.”

Logically, why would a bank not do this? We would, if a purpose would meaningfully reduce RWA. We think there is a fine line between efficient risk management practices and the Basel Committee’s call to avoid capital arbitrage. While recognizing that the Basel Committee’s job is to avoid loopholes, this one seems tough. By dramatically increasing the present value accounting of CDS on risk capital books, this may be a case of trying to solve each individual loophole rather than go for a principal based approach, which might ultimately be easier to do rather than rely on the Committee’s proposed “materiality” proposal for national regulators to evaluate.

The Reuters article, “Europeans lobby Fed’s Tarullo over bank curbs,” is a case of one man’s ceiling being another man’s floor. The US specific Dodd-Frank capital requirements have had US banks arguing that the DF provisions of capital and credit exposures would overly penalize their businesses relative to foreign banks. We’ve commented on this regulatory discrepancy in the past, and agree with the US banks that an unequal US regulatory playing field would be a business disaster. Now, European banks are fighting bank for their interests. According to Reuters:

“Tarullo’s plan would force foreign banks to group all their subsidiaries under a holding company, subject to the same capital standards as U.S. holding companies. The biggest banks would also need to hold liquidity buffers.

“The Institute of International of Bankers (IIB) held a conference call on Friday to prepare a letter the lobby group plans to send to the Fed to complain about the rule, a source who was on the call told Reuters.

“The bloc’s financial services chief, Michel Barnier, raised these concerns when he met with Tarullo last month in Washington to urge better cooperation between the United States and EU so they could rely on each other’s bank supervisors without the need for “ring fencing.”

“If we choose to part ways, this will send the wrong signal to markets and to the rest of the world. It would increase the cost of capital, and reduce growth prospects,” Barnier said during his visit.

“Deutsche Bank is cited as one case that could need more capital for its U.S. business, with French banks not far behind, though their lack of disclosure makes it difficult to calculate how big the shortfall is, a London-based bank analyst said.

“Most European banks have been subsidizing their U.S. units with capital from their European franchises,” the analyst said. “The French do not give any real disclosure for their U.S. units, but knowing their style one can imagine that the level of capital is not going to be that great.””

Tarullo’s proposed rules are a huge deal in US financial markets. If new Dodd-Frank capital and credit exposure limits are considering for US banks only, that will result in a substantial disadvantage for US banks over their foreign rivals. However, if all foreign banks are made to form US holding companies and account for their capital under US rules, foreign banks will be similarly disadvantaged. The lobbying has begun with heavy stakes on the outcome.

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