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A Note on Regulatory Arbitrage: Bank Risk, Capital Risk, Interest Rate Risk and ALM in European Banking

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Liquidity Risk, Efficiency and New Bank Business Models

Abstract

Interest rate risk and its management are one of the classic activities of banking operations, classified as asset and liability management (ALM). This chapter considers ALM as a possible avenue for regulatory arbitrage under regulatory capital constraints. The theoretical purpose is to present a theory of regulatory arbitrage as a regulatory response to capital requirements in banking depending on capitalisation mechanisms. The empirical purpose is to analyse capital risk and bank risk in European banking in terms of ALM. The theoretical and empirical results presented support observations of a possible loophole in today’s capital regulations via ALM and of regulatory arbitrage as a regulatory response. In addition, it is more likely that low-capitalised banks utilise ALM as a way to counter higher levels of capital regulation.

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Notes

  1. 1.

    The difference between the accords primarily lies in their definitions of the capital for capital requirement, in their estimations of risk weighted assets (RWA) and in the capital requirements based on the RWA. For Basel I, the RWA was only estimated for credit risk (market risk in a later addendum), and in Basel II and Basel III, credit risk, market risk and operational risk each estimate RWA via different methods and capital requirements. For Basel I and Basel II, the total capital requirement was 8 % of RWA, and Basel III will, when fully implemented, result in a total capital requirement of 12.5 % of the RWA.

  2. 2.

    Regulatory-regime inconsistency denotes that regulatory treatments are different under different regulatory regimes, and economic-substance inconsistency denotes that under the same regulatory regime, transactions with identical cash flows receive different treatment. Time inconsistency denotes that depending on time or timing factors, regulatory treatments differ.

  3. 3.

    Interest rate risk is not addressed in pillar I of the Basel regulations, but it has been addressed in several reports (BCBS 1993, 1997, 2004). For instance, Basel I includes a reminder to not disregard interest rate risk. The EBA (2015) recently suggested that interest rate risk be made part of pillar II (the supervisory review).

  4. 4.

    GAP = IEA − IBL, where IEA is the volume of interest-earning assets and IBL denotes interest-bearing liabilities. The effect on the interest income at (NII) interest rate(r) is: ∆NII = GAP × ∆r.

  5. 5.

    Duration GAP = DIEA − (IEA/IBL) × DIBL, where DIEA and DIBL are the durations of interest-earning assets and interest-bearing liabilities, respectively. IEA and IBL denote the volume of interest-earning assets and interest-bearing liabilities, respectively.

  6. 6.

    Economic capital may decrease due to an overall reduction in risk levels, but in the interest of simplicity and for illustration purposes, the economic capital is held constant.

  7. 7.

    This policy discussion is not the focus of this study. Rather, we focus on the bank’s strategic decisions made when presented with regulatory arbitrage opportunities.

  8. 8.

    Two sub-categories of banks were included in our search: ‘commercial banks’ and ‘bank holding and holding companies’.

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Authors and Affiliations

  1. Linnæus University, Växjö, Sweden

    Magnus Willesson

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  1. Magnus Willesson
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Editors and Affiliations

  1. Bangor Business School and FUNCAS , Bangor, United Kingdom

    Santiago Carbó Valverde

  2. University of Granada, Granada, Spain

    Pedro Jesús Cuadros Solas

  3. University of Granada, Granada, Spain

    Francisco Rodríguez Fernández

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Willesson, M. (2016). A Note on Regulatory Arbitrage: Bank Risk, Capital Risk, Interest Rate Risk and ALM in European Banking. In: Carbó Valverde, S., Cuadros Solas, P., Rodríguez Fernández, F. (eds) Liquidity Risk, Efficiency and New Bank Business Models . Palgrave Macmillan Studies in Banking and Financial Institutions. Palgrave Macmillan, Cham. https://doi.org/10.1007/978-3-319-30819-7_2

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