Monday, 21 September 2009

Why Is Regulatory Arbitrage So Attractive?

When the histories of today’s very interesting times are finally written, I suspect that the phrase ‘regulatory arbitrage’ will feature prominently. One may point to the housing bubble or the bubble in finance as proximate causes; or to unsustainable global macro imbalances as a more distant cause. But the grease that lubricated the wheels of the runaway train was regulatory arbitrage.

Why was regulatory arbitrage so prevalent during the boom? There are several reasons.

First, regulatory arbitrage is easy. It’s certainly easier than trying to beat the market in ‘legitimate’ ways, as many retired traders can testify. What’s more, this state of affairs is likely to persist. Regulatory agencies in the USA are notoriously understaffed; their few workers are notoriously underpaid. Anyone competent enough to understand the complexities of modern financial instruments (which, incidentally, are often designed specifically to avoid or evade regulatory scrutiny) would waste little time in quitting and joining the very Wall Street firms he is supposed to be monitoring. Add in the phalanxes of lawyers and compliance officers whose job it is to ensure that the shenanigans stay on the right side of the letter of the law, and it’s an unequal battle. The investment banks will always win.

Perversely, this outcome is often reinforced by legislative action. Consider the practice of jurisdiction-shopping, wherein firms migrate their corporate entities to domiciles where the regulators are friendlier, or set up multiple entities in various jurisdictions such that key issues ‘fall through the cracks’. Confronted with this reality, the dominant response on the part of legislators has been to ease regulatory burdens, so as to stanch the corporate exodus. Unchecked, this merely leads to a race-to-the-bottom as countries compete to offer the most lax regimes. The long-term consequences of such a race can be devastating, as recent events make clear.

Second, regulatory arbitrage, unlike say interest rate arbitrage or index arbitrage or cross-border arbitrage, is true arbitrage: the arbitrageur takes no market risk at all. In all other real-world arbitrages, the arbitrageur takes some sort of liquidity or timing or event risk. Even if the final outcome is a guaranteed profit, there may be some path along which the arbitrageur goes bankrupt before he can realize that profit. This is not the case with a ‘pure’ regulatory arbitrage.

It gets even better: the diminished market risk means that the arbitrageur can take much larger positions, and presumably make much larger profits. (Consider the case of SIVs designed to stockpile risky assets off bank balance-sheets. If the assets do well, the bankers get paid. If the assets do badly, well, nothing happens – they weren’t on the bank’s balance sheet, so who cares?) Regulatory arbitrage is thus not only easier than other forms or arbitrage, it is also more lucrative.

But what about non-market risk? Clearly, if regulatory arbitrage is sufficiently widespread, the system as a whole can come crashing down. (Think of the role played by credit ratings abuse in inflating the housing bubble.) Unfortunately, risks to ‘the system as a whole’ are not borne by individual bankers. This brings us to our third contributory factor: incentives. Thanks to the quarterly-earnings / annual-bonus culture on Wall Street, practitioners have almost no incentive to play for the long term. Indeed, anyone who chooses to do so would be quickly forced out or passed over in favor of his more aggressive colleagues. Poorly-structured incentive schemes reinforce the attractiveness of regulatory arbitrage, and ensure that traders will take full advantage of any loopholes they can find.

Will things change? It’s unlikely. The talent mismatch between regulators and Wall Street is not going to diminish. Nor are traders going to be held accountable for non-market risks; indeed, if anything the bailouts have firmed the Street’s expectation that systemic risks will always be backstopped by the government (moral hazard, anyone?). And regulatory arbitrage will continue to be easier as well as more lucrative than other forms of speculation.

The only way to prevent regulator arbitrage is to eliminate the incentive structures that support it. But even if the government took advantage of its post-bailout leverage to impose drastic salary caps or other behavioral restrictions (a scenario improbable in the extreme, given the current condition of de facto state capture), bankers would simply work their way around them. The example of Barclays makes this eminently clear:
Two former Barclays execs are starting a fund called Protium Finance. Protium has two equity investors who are putting in $450 million. Barclays is lending Protium $12.6 billion. Protium is using the cash to buy $12.3 billion in what we used to call toxic assets from Barclays. Protium’s 45 staff members get a management fee of $40 million per year.

Although Barclays is recognizing its exposure to Protium, Protium is a different company, and it’s not a bank. That’s important these days, and this is Tett’s main point. In particular, because it’s not a bank, British regulators can’t do anything to it. In particular, they can’t prevent Protium from paying its managers whatever they want to pay it, and they probably can’t force Protium to even tell them what its managers are making.

So here we have the ultimate form of regulatory arbitrage. If you’re a bank exec worried about public exposure or, even worse, regulation of your compensation, go create a new special-purpose vehicle to manage bank assets, entice the equity investors in with a sweetheart deal, and pay yourself whatever you want.
Brilliant, devious, lucrative, and almost impossible to police. That, I’m afraid, is regulatory arbitrage in a nutshell.

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