Regulatory Arbitrage Did Not Cause The Current Banking Crisis

Banks Need Adjustable Capital Amounts Sensitive To Future Economic Conditions

Regulatory capital ratios capture firm specific events but do not capture economy wide events. Regulatory arbitrage did not cause the current banking crisis and its complete elimination would not prevent a repeat of the current banking crisis.

Regulatory capital is set by lending and investment categories, such as mortgages, but the computed capital ratio is formulaic, static and does not vary by regional or US economic conditions. Additionally, it is in part dependent on outside ratings by credit rating agencies, especially SEC approved NRSROs, which are lagging indicators of changing riskiness and default rates instead of leading indicators.

Holding $100 million of residential mortgages outright or holding the same dollar amount of securitized residential mortgages does not change the risk the institution faces. The regulators compute regulatory capital by form instead of the substance of the asset, and the institution can free up required capital by modifying the form of its holding and use the extra capital to increase its holdings and concentration in that asset, i.e. engage in regulatory arbitrage. Effectively, the increase risk comes from increased leverage and loss of diversification through an increase in a particular asset concentration.

Additionally, since regulatory capital ratios do not change to reflect changing economic conditions, the regulators require banks to hold the same amount of regulatory capital in growth as in recessionary economic times. We know asset default risk is not constant and changes based upon different regional and US economic conditions, e.g. during periods of higher regional unemployment, regional residential mortgage default rates will increase. Similarly, area home values decline during regional economic downturns and the decline in value increases an area's mortgage default rates.

High unemployment rates along with a substantial decline in home values are the cause of the high mortgage default rates. A lingering, worsening recession was the underlying cause.

There are areas of the US where the decline in home values is 20-50 percent from their highs. In many areas of the US, unemployment is at 25-year highs, if not higher. If banks did not arbitrage from direct holdings of residential mortgages into securitized mortgages, banks would still face substantial write-downs. Residential mortgage defaults would still be higher than usual or expected (by capital set aside) due to substantial home value declines and high unemployment.

Weak US and regional economic conditions and their effects severely affected the value of all residential mortgages and their default rates. It is extremely likely that banks would need to raise capital, face heightened regulatory scrutiny and increased risk of government takeover independent of the form of their mortgage holdings. Even if we had restricted the amount of residential mortgage holdings of any form prior to this economic downturn, the banks would have invested their funds in other earning assets, such as credit cards, commercial loans or commercial real estate. All loans face higher default rates in bad economic times and just about all assets lose value.

What we need is a more sensitive, adjustable capital ratio to future economic conditions. Requiring capital based on sensitivity analysis (stress tests) requires banks to hold more capital than necessary in good times, acts contra-cyclically by restricting lending in good economic times, and lowers the earnings of banks.

Since economic forecasting of turning points in the economy is notoriously poor, market based solutions, such as market valued balance sheets, are probably the best but they are not fool proof. Market values of long-term assets, such as mortgages, reflect all expected losses including those several years in the future. The market value accelerates the future expected default into the present. For example, suppose an apartment building has a 20-year balloon mortgage with a constant yearly interest payment. The likelihood of default during the early years of interest payments may be quite low, but the market may have high expectations of default at the end of the twenty years on the final balloon principal payment. The market could easily value the mortgage at 60 to 70 percent of its face value. The discounted value would force the bank to either increase its current capital base or decrease it lending. The bank would feel the effect of the future default now, many years before it would realize the default and be necessary for it to replenish its capital base. Asset based market valuations for long-term assets could affect lending and investment in a counter-cyclical fashion.

One would have to rerun recent banking history under an alternative, proposed regulatory structure and reconstruct a bank's new balance sheet. We could see, based on new, proposed restrictions, prior to going into this recession, if there is anything that would be different now under a different set of rules and if the banking industry could have avoided its current crisis by lending and investing differently.