Abstract
Financial innovations often respond to regulation by sidestepping regulatory restrictions that would otherwise limit activities in which people wish to engage. Securitization of loans (e.g., credit card receivables, or subprime residential mortgages) is often portrayed, correctly, as having arisen in part as a means of "arbitraging" regulatory capital requirements by booking assets off the balance sheets of regulated banks. Originators of the loans were able to maintain lower equity capital against those loans than they otherwise would have needed to maintain if the loans had been placed on their balance sheets.
Capital regulation of securitization invited this form of off-balance sheet regulatory arbitrage, and did so quite consciously. Several of the capital requirement rules for the treatment of securitized assets originated by banks, and for the debts issued by those conduits and held or guaranteed by banks, were specifically and consciously designed to permit banks to allocate less capital against their risks relating to those conduits than they would have had to maintain against similar risks if they had been held on their balance sheets (Calomiris 2008a). Critics of these capital regulations have rightly pointed to these capital requirements as having contributed to the subprime crisis by permitting banks to maintain insufficient amounts of equity capital per unit of risk undertaken in their subprime holdings.
Investment banks were also permitted by capital regulations that were less strict than those applying to commercial banks to engage in subprime-related risk with insufficient budgeting of equity capital. Investment banks faced capital regulations under SEC guidelines that were similar to the more permissive Basel II rules that apply to commercial banks outside the US. Because those capital regulations were less strict than capital regulations imposed on US banks, investment banks were able to lever their positions more than commercial banks. Investment banks' use of overnight repurchase agreements as their primary source of finance also permitted them to "ride the yield curve" when using debt to fund their risky asset positions; in that respect, collateralized repos appeared to offer a substitute for low-interest commercial bank deposits. But as the collateral standing behind those repos declined in value and became risky, "haircuts" associated with repo collateral became less favorable, and investment banks were unable to roll over their repos positions, a liquidity risk that added to their vulnerability and made their equity capital positions even more insufficient as risk buffers.
There is no doubt that the financial innovations associated with securitization and repo finance were at least in part motivated by regulatory arbitrage. Furthermore, there is no doubt that if on-balance sheet commercial bank capital regulations had determined the amount of equity budgeted by all subprime mortgage originators, then the leverage ratios of the banking system would not have been as large, and the liquidity risk from repo funding would have been substantially less, both of which would have contributed to reducing the magnitude of the financial crisis.
And yet, I do not agree with those who argue that the subprime crisis is mainly a story of government "errors of omission," which allowed banks to avoid regulatory discipline due to the insufficient application of existing on-balance sheet commercial bank capital regulations to the risks undertaken by investment banks and off-balance sheet conduits. The main story of the subprime crisis instead is one of government "errors of commission," which were far more important in generating the huge risks and large losses that brought down the U.S. financial system.