Paging Simon Johnson and James Kwak
By Arnold Kling
One of the themes of their baseline scenario blog is that banking regulators have been captured by large banks.
In researching the history of capital regulation, I came across this paper by David Jones, of the Federal Reserve Board. It was written in 2000, and it describes how securitization and off-balance-sheet entities were used for regulatory capital arbitrage, meaning that it allowed banks to hold the same assets but less capital.
Although academic articles by Federal Reserve Board economists routinely carry a disclaimer that they do not reflect the opinions of the Board or its staff, the article clearly shows that the Fed was aware of regulatory capital arbitrage (RCA)and it paints a largely sympathetic picture of the phenomenon.
Since the underlying securitized assets tend to be of relatively high quality, a strong case can be made that the low capital requirements against these retained risks actually may be appropriate…
Unless these economic and regulatory measures of risk are brought into closer alignment, the underlying factors driving RCA are likely to remain unabated. Without addressing these underlying factors, supervisors may have little practical scope for limiting RCA other than by, in effect, imposing more or less arbitrary restrictions on banks’ use of risk unbundling and repackaging technologies, including securitization and credit derivatives.
Such an approach, however, would be counterproductive (and politically unacceptable).
The thinking was that the Basel capital accords required banks to hold too much capital for mortgages (this was probably true). Accordingly, the article takes a sympathetic view of regulatory arbitrage. In retrospect, this is a bit like watching a movie in which a jailer becomes sympathetic to a prisoner, when we know that the prisoner is eventually going to escape and go on a crime spree.