Danièle Nouy of ECB on Dealing with Regulatory Arbitrage

ECB’s ongoing targeted review of internal models at over 60 banks, including all eight of the globally significant banks supervised in the euro area, is an important step toward dealing with the challenge of regulatory arbitrage. Supervisors need to scrutinize what bankers do and examine individual transactions to see whether they might be an attempt to game the rules. Ms. Nouy discusses three types of regulatory arbitrage and how it can be dealt with:

Cross-Jurisdiction Arbitrage, which exploits differences in rules for banks from one country to another. In Europe, cross-jurisdiction arbitrage has become even more of an issue in the context of Brexit. Thus, harmonization of rules is a powerful tool when it comes to preventing cross-jurisdiction arbitrage. Transposing the Basel and European rules into national law is important in this context, thus making a case for further harmonizing the European rulebook. To that end, we should rely less on EU directives and more on EU regulations, which are directly applicable in all member states.

Cross-Framework Arbitrage, which arises because some parts of the financial sector, such as the shadow banking sector, are less regulated than the highly regulated banking sector. If banks shift exposures to shadow banks, they become vulnerable to what is known as “step-in risk,” which must be addressed. With this in mind, BCBS has made step-in risk part of its official work program and is working on guidelines for banks and supervisors. These guidelines contain a number of criteria that will help to assess step-in risks for individual banks and they propose measures aimed at helping banks to deal with such risks. The guidelines will not contain automatic Pillar 1 capital or liquidity add-ons. Instead, they will provide a list of potential measures that leverage existing tools. It will be up to the banks to choose the most appropriate measures, while supervisors will check and challenge the choices banks make.

Intra-Framework Arbitrage, in which rather than trying to exploit differences between two or more sets of rules, banks try to exploit loopholes within a single set of rules. Here, ECB is more concerned with closing loopholes rather than harmonizing rules and preventing the spillover of risks. One solution could be to change the rules in such a way that loopholes are closed. However, for this to be effective, regulators would first have to identify every loophole, which we all know is impossible. So it makes sense to also apply tools that have a broader and more preventive effect: such measures are already being implemented. The rules nowadays focus on more than one dimension. "Thanks to Basel III, banks around the world now face multiple constraints: the risk-weighted capital ratio has been supplemented by a leverage ratio and liquidity ratios. These constraints reinforce each other, which makes it much more difficult for banks to game them."

Related Link: Speech

Keywords: Europe, EU, Banking, Regulatory Arbitrage, Shadow Banking, Step-in Risk, Single Rulebook, ECB