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.
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.
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.
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