“Regulatory Arbitrage Within the Firm“ by Dr. Nicola Cetorelli and Assistant Professor Shohini Kundu is a sobering read. In this Federal Reserve Bank of New York Staff Report the authors explored how banks have been shifting risks to comply with post-2007-2009 bank regulations. Cetorelli and Kindu analyzed how Large Bank Holding Companies (BHCs)—which own both heavily regulated commercial banks and lightly regulated “nonbank” affiliates—manage capital internally.
Key Findings: Shifting the Safety Net
The authors uncovered an internal game of musical chairs with capital, which no doubt banks would argue was triggered by stricter regulations.
- The Basel III Response: When stricter Basel III capital requirements were phased in starting in 2015, BHCs faced massive pressure to make their commercial banks look safer. Instead of raising expensive new money from outside investors, parent companies extracted equity from their nonbank subsidiaries and funneled it into their commercial bank arms. Unfortunately, bank regulators did not compel banks to raise high quality capital externally.
- The “Safer” Bank Illusion: Because of these internal equity transfers, bank subsidiaries accumulated 5 to 8 percentage points more excess capital than comparable, standalone banks that didn’t have nonbank siblings.
- The Trade-Off: While the bank subsidiaries looked rock-solid, the nonbank affiliates suffered. Their capital ratios plummeted, their credit quality deteriorated, and they shifted aggressively into riskier consumer lending to make up for the capital drain.
- Zero Net Change: At the consolidated group level, total equity, total assets, and overall lending remained completely unchanged. Risk was not eliminated; it was just moved to a different room in the house.
Implications for the Banking System: Hidden Fragility
The core implication is that the post-crisis banking system is not as safe as it looks on paper.
- Overstated Safety: Regulators look at commercial bank balance sheets and see healthy capital buffers. However, this safety is a mirage because it ignores the structural decay happening right next door inside the same parent company.
- The Chain Reaction Risk: The consolidated parent organization remains deeply exposed to its weakened nonbank affiliates. If those nonbank arms suffer heavy losses, the parent company faces an implicit liability to rescue them to save its own reputation and operational survival.
- The Stress Test Shock: The authors simulated a crisis using 2008-scale losses on nonbank assets. They discovered that if parent organizations were forced to bail out their distressed nonbank affiliates, 4 to 6 percent of all Bank Holding Companies would completely exhaust their capital buffers, pushing them to the brink of failure.
What Bank Regulators Should Do
Cetorelli and Kindu emphasize that organizational structure is a fundamental determinant of whether a regulation succeeds or fails. No only is this definitely not the time to deregulate banks, it is time to fix any loopholes. Bank regulators need to change how they measure and enforce safety standards:
- Adopt True Consolidated Supervision: Regulators cannot look at commercial banks in isolation. They must assess the financial health, capital adequacy, and risk profile of the entire holding company holistically, actively penalizing internal capital shifting.
- Account for Implicit Liabilities: When assessing a bank’s capital buffers, regulators must factor in the “shadow” risk of its affiliates. If a bank has a heavily leveraged, under-capitalized nonbank sibling, its required capital buffer should be higher to account for a potential emergency bailout.
- Close Asymmetric Loopholes: The root cause of this behavior is that prudential regulations bind asymmetrically (stricter on banks, looser on nonbanks). Bank regulators need to harmonize rules for entities under the same corporate umbrella so that internal capital markets cannot be used as a vehicle for regulatory arbitrage.
Until regulators solve these problems, bank capital musical chairs will continue. And when a bank falls, I sure hope that taxpayers will not be forced to do the picking up.
