This Crisis Was Not Caused by Regulatory Arbitrage

 |  About: KeyCorp (KEY)
by: Eric Falkenstein

I was in charge of economic capital allocations at KeyCorp (NYSE:KEY).We allocated 'economic' or 'risk' capital within the bank. This exercise was used for reporting, pricing, compensation, and risk management. One issue that often arose was what to do when the economic risk capital allocation was different than the regulatory capital allocation. I wrote an article in Bank Accounting and Finance in 1997 on this issue. As there were relatively few buckets for regulatory capital--6% for most assets, 2% for OECD debt--the issue was always present. But 'arbitraging' regulatory capital was only recommended when the estimated risk capital was lower than the regulatory capital. That is, people don't increase leverage by securitizing unless they believe, and their debtors believe, they do not need the capital required by regulators. You arbitrage it when it is too high, not too low. Banks don't intentionally take on too much risk.

Felix Salmon notes that one can reduce one's regulatory capital requirement by about 1% by securitizing. That's fine, but in general banks that could avail themselves of this strategy were not increasing leverage over the past 20 years. Most estimates of the required risk capital were much lower than regulatory capital, around 2-3%, because they were assumed to have their historical credit loss rates, which were de minimus. That was a mistake, to be sure, and people like Peter Schiff were spot on in seeing that, but it was the best estimate of academics, investors, and bankers.

Thus, the idea that we need to prevent regulatory arbitrage presumes this is because risk capital is greater than regulatory capital requirements in certain circumstances. With hindsight, there was too little capital allocated for mortgages originated between 2005 and 2007. Then again, with hindsight, they had a negative NPV, and should not have been issued by any rational profit maximizing firm. But that's hindsight. The market risk capital for those assets is probably much higher than any regulatory requirement right now. This is a problem that does not need fixing, because bankers do not take on too much risk on purpose. If the regulatory capital requirement is 2%, and your assessment is 6%, you allocate 6% unless you have excess capital from other investments. The idea that bankers knew the asset required a 10 to 1 leverage ratio, but chose 30 to 1 because regulations allowed it, is like assuming that people drink 12 shots of scotch in 30 minutes because it is legal to do so. The key reason is the willingness, not the legal ability. It is impractical to design a legal system that will capture the myriad nuances involved in allocating capital to literally thousands of different bank liabilities. Currently there are 3 different regulatory capital buckets (OECD government debt, A rated investments, and other). In a few years, this might change to 5.

The bottom line is this crisis was not caused by regulatory arbitrage, but rather, everyone assuming mortgages had much less risk than they did, or do. You should not give a mortgage to someone who can't pay for it on the presumption that collateral never declines in value. We now know mortgages are much riskier than we thought in 2006. Bankers do not lever investments more than they should merely because it is feasible under the regulatory requirements. Like the Space Shuttle disaster, fixing the specific cause of the last crash is easy (more resilient O-rings). Having a mechanism that better anticipates the next unknown failure is not so simple.