Against regulations

“The root cause was regulatory arbitrage at the banks. Regulatory arbitrage describes actions someone takes in order to avoid the affects of some set of regulations that might apply to them if they ran their business differently. Rather than buying some asset in a jurisdiction where it is taxed, you have a subsidiary buy it, or you buy an option, or you buy a company that already owns it. If one kind of institution can’t engage in a certain practice that looks like it’ll make money, then people will invent a new kind of institution that’s subject to different regulators which isn’t so prohibited.

Part of my long riff on the crash has been that practically every financial institution that exists now is the result of regulatory arbitrage of some kind. Consumer banks accept deposits, but their activities are tightly regulated in order to qualify for deposit insurance, so commercial banks don’t take deposits from consumers. Credit Unions have a different set of restrictions on their activities. Savings and Loans were restricted in the interest they could charge on loans, so when they had to compete on the interest they paid on deposits, they took excessive risks leading to the S&L crisis. Commercial bank investments are regulated and limited, so there are investment banks. Those have their own regulations, so we saw the rise of hedge funds which didn’t have to report to anyone except their investors.

“The regulatory arbitrage at the root of this crisis was that the consumer banks were restricted in what assets they can hold and what assets they can sell. So the mortgage-backed securities (MBS) they were selling stripped out the lucrative part of the loan repayment income stream and sold that for cash they could use to make more loans, while they ended up keeping the riskiest part on their books. Most of them found tools that appeared to insure against the remaining risks, but those were systemically flawed–all the banks relied on the same few institutions, and their back-up plans would only have worked if problems were isolated. When the crunch came it was general, and so all the back-up plans failed together.”

“Bad solutions attempt to forbid certain kinds of actions or investments, since they provide an incentive to find a new kind of institution that can exploit the abandoned opportunity. It’s better, when we detect a kind of transaction that is destabilizing in one way or another to find a way to allow it that makes its impact and extent visible and provides incentives to moderate the impact. That’s not easy, and it’s probably not the direction that regulators and legislators will want to go, but forbidding lucrative practices doesn’t prevent them, it drives them underground and out of sight.”

Source: Financial crisis: Regulatory Arbitrage

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