Basel II - Capital Arbitrage

Capital Arbitrage
If a loan is calculated to have an internal capital charge that is low compared to the 8% standard, the bank has a strong incentive to undertake regulatory capital arbitrage


Securitization is the main means used by U.S. banks to engage in regulatory capital arbitrage.



Example of Capital Arbitrage
Assume a bank has a portfolio of commercial loans with the following ratings and internally generated capital requirements


AA-A: 3%-4% capital needed


B+-B: 8% capital needed


B- and below: 12%-16% capital needed


Under Basel I, the bank has to hold 8% risk-based capital against all of these loans


To ensure the profitability of the better quality loans, the bank engages in capital arbitrage--it securitizes the loans so that they are reclassified into a lower regulatory risk category with a lower capital charge


Lower quality loans with higher internal capital charges are kept on the bank’s books because they require less risk-based capital than the bank’s internal model indicates.

No comments:

Post a Comment