Last week, four U.S. Senators sent a letter to the heads of the major financial regulators expressing concern about extending U.S. swaps regulation outside of the U.S. A primary focus of the letter was preventing duplicative or inconsistent regulation from harming U.S. competitiveness. However, the Senators also expressed concern with potential harm from regulatory arbitrage that arises from inconsistent regulation across national jurisdictions.
Regulatory arbitrage acheived by conducting transactions outside of the U.S. may not be a significant problem, however. The primary type of arbitrage underlying the financial crisis was not about avoiding regulation per se, and certainly not by transacting outside of the U.S. Rather, the arbitrage that did occur was more indirect; it took advantage of domestic regulations that failed to account for the true risk of certain transactions.
In particular, certain transactions took advantage of the fact that risk-based bank capital regulation gave too much relief, but the amount of relief given was by design. When banks sold assets to conduits and provided liquidity guarantees, or held onto AAA-rated mortgage-related securities to benefit from their relatively low capital charges, they were not so much avoiding regulation as complying with regulations that made risky transactions more profitable. In the case of AIG, the company was brought down by the swaps it sold for parties to hedge risk, not its larger portfolio of swaps that gave European banks regulatory capital relief. (See footnote 94 and accompanying text from the June 2010 Congressional Oversight Panel report).
Regulators should thus be mindful that the biggest danger to the regulatory regime now emerging is probably not that market participants will transact around it abroad, but rather that too many participants will actually comply with it in a way that ultimately increases risk. Newly moving swaps to central counterparties (CCPs) may be just such a development, as parties are now "placing a lot of reliance on regulators to get these standards right and ensure CCPs are really robust."
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