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Gaming The Bank Regulation System: A Primer

It’s eye opening to reflect that the Basel III requirements are the joint production of more than 500 representatives from 27 nations, including top regulators and central bankers. They met dozens of times this past year. They produced 440 pages of new rules.

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But those rules are just as open to regulatory arbitrgage—a fancy phrase for gaming the system—as ever.

Let’s take a quick example of how a banks can easily shrink the amount of regulatory capital they need for a loan, and subsequently increase their overall leverage. (For real finance nerds, read the OECD paper from which this example is borrowed.)

Imagine that Bank of America ends $1 million to a BBB rated company. That loan comes with a 100 percent risk weighting, which—under the 7 percent Basel III capital requirement—means that Bank of America would have to set aside $70,000 in capital.

Bank of America would rather not set aside $70,000, so it buys a credit default swap from JPMorgan Chase . Because JPMorgan is a bank, the CDS has just a 20 percent capital weighting. This means that Bank of America must now set aside just $14,000 in capital for the loan.

JPMorgan, however, doesn’t want to set aside the necessary capital for the loan, either. So it goes to a non-banking insurance company and buys another swap. (Note: this buying swaps to cover swaps is totally standard, and is one reason the market for derivatives is so huge.)

So how do we figure out how much capital JPMorgan has to set aside. First, you take the CDS spread price—let’s say it’s a 500 basis point spread, amounting to $50,000, plus a regulatory surcharge on the face value of the the bond ($15,000). That total—$65,000—gets divided in half because the off balance sheet risk is given a 50 percent risk weighting. So now we’ve got a total of just $32,500 in risk weighted assets, against with JPMorgan has to create an 8 percent reserve. That amounts to a reserve requirement of $2,560.

The insurance company exists outside the banking system, so the Basel III capital requirements don’t follow the risks any further.

The two banks have now reduced the capital that needs to be set aside for a $1 million loan from $70,000 to just $16,560.

The thing to take away from this little exercise is that almost everything you read about capital requirements going to 7 percent from 8 percent is describing an illusion. The reality is that the actual amounts set aside are far lower once banks use derivatives and off-balance sheeting to reduce their paper exposure.

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