Regulatory arbitrage could go far beyond Basel III

March 10, 2011

Regulatory arbitrage is the latest buzz-phrase. The financial industry’s parlor game is guessing whether Swiss, British or U.S. banks will end up with the toughest rules on capital and liquidity. But as reforms play out around the world, for instance in derivatives, there’s also the possibility that entire business lines will migrate — raising a whole new set of systemic risks.

Headlines often focus on which country’s banks will win or lose. Here, one big issue is the Basel III rules boosting bank capital, especially the extra cushion national regulators may force the biggest banks to hold. Some in Europe, including this week Oswald Gruebel, chief executive of UBS, worry that the Americans, having dragged their feet in adopting Basel II, will crawl at snail’s pace this time around, too. Conversely Sheila Bair, chairman of the U.S. Federal Deposit Insurance Corp, seems to think it’s in parts of Europe that the political will is questionable.

The lens of bank nationality is used widely. Analysts at JPMorgan this week outlined how European investment banks like UBS and Credit Suisse could benefit, overall, compared with their Wall Street counterparts. That side of the Atlantic, banks will not suffer the constraints of the so-called Volcker rule that limits the trading activities of U.S. banks, nor will they have to segregate derivatives and banking activities as American reforms require. Those benefits, JPMorgan reckons, outweigh greater constraints on pay in Europe.

But there are broader issues. Take over-the-counter derivatives. The U.S. Dodd-Frank Act is forcing most trading into central clearing houses or onto exchanges. European rulemakers look likely to follow suit. Asian marketplaces like, say, Singapore are still mulling what to do. Even if central clearing becomes the global norm, the regulations attached to clearing houses could dictate where banks and other market players like hedge funds — whether headquartered in Zurich, London or Greenwich — transact their derivatives business.

There’s a danger that the regime that ties up the least amount of traders’ capital is likely to win out, especially if one or more big financial centers were to impose rules seen as draconian. At least in theory, that in turn could eventually encourage the emergence of a large clearing hub — posing, almost by definition, a major cross-border risk — in a jurisdiction the reg-arb worriers don’t have the measure of. Where banks do business can matter more to the system than where their bosses sit.

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