Regulatory arbitrage and model sophistication in the financial crisis

Abstract

This paper investigates the financial institutions’ strategies behind the recent financial meltdown. These strategies have certain features in common. First, before 2007, they were all considered as arbitrage opportunities. Secondly, regulation loopholes and model sophistication were vital for their profitability. Thirdly, markets were unable to assume their traditional role of suppressing these opportunities, at least before the imbalance they generated had become so heavy that they collapsed under their own weight. This paper argues that any reform of the regulation of financial institutions will open the field to a new wave of financial innovations, all with the primary goal of circumventing the new regulations — something that regulators and financial institutions would do well to remember. Beside global reforms, one must look carefully at more microeconomic considerations. In this respect, auditing the performance and return on (regulatory) capital of main desks and business lines/products within financial institutions could be a practical way to track extraordinary return-on-equity, which in turn is probably the most accurate guide to knowing where the next accident will take place.