10
By Hilary Schmidt, International Banker
Regulatory arbitrage refers to the practice of large financial institutions (and other corporations) of operating across jurisdictions and structuring transactions to take advantage of favourable regulatory environments, ultimately minimising the overall regulatory burden. This allows them to exploit loopholes in the rules to minimise costs whilst remaining compliant, although such cost reductions are not necessarily accompanied by corresponding reductions in underlying risks.
For example, research has found that a multinational bank engages in regulatory arbitrage by choosing a location to originate its share of syndicated loans. Using the data of more than 214,000 cross-border syndicated loan contributions by 42 multinational banking groups headquartered in 10 countries that provided loans to borrowers in 151 countries over the 1999-2014 period, a 2023 paper from the Center for Global Development (CGD) examined how the loan-location choice and the intensity of regulatory arbitrage are affected by borrower transparency. The study revealed several significant findings:
- More stringent capital regulations reduce the probability of loan origination in a country. “We see strong evidence of regulatory arbitrage. Since our data cover a relatively long period, we are also able to examine whether the intensity of regulatory arbitrage has changed over time, particularly following the financial crisis of 2008-2009,” the authors noted. “Indeed, the fraction of cross-border loans that have been arbitraged peaks in 2008 and significantly declines afterwards, potentially due to post-crisis changes in the regulatory regime and stronger enforcement through supervision.”
- Regulatory arbitrage is more intense for weaker banks and riskier borrowers, with better capitalised banking groups engaging in less arbitrage. This is because such banks face less binding capital constraints and are thus less incentivised to engage in regulatory arbitrage to avoid potentially onerous capital regulations. Loans to safer borrowers also attract lower regulatory risk weights and thus require less regulatory capital.
- Loan-location choices reflect a trade-off between ease of borrowers’ information acquisition versus the need to evade stricter capital regulations, with loans more likely to be issued in the borrower’s country or in a country that specialises in the borrower’s industry. The easier it becomes to obtain information about prospective borrowers, however, the more the location choice becomes sensitive to regulatory differences, leading to more intense regulatory arbitrage.
Not all banks engage in this controversial practice, however. A 2015 study by Ohio State University found that only some banks engage in regulatory arbitrage, hypothesising that banks wanting to be riskier than allowed by capital regulations employ this tactic, while other lenders do not.
“We find support for this hypothesis using trust preferred securities (TPS) issuance, a form of regulatory arbitrage available to almost all US banks from 1996 to Dodd-Frank,” the paper noted. “We also find support for predictions that constrained banks are riskier, perform worse during the crisis, and use multiple forms of regulatory arbitrage. We show that neither too-big-to-fail incentives nor misaligned managerial incentives are first-order determinants of this type of regulatory arbitrage.”
Despite growing global cooperation among banking supervisors to harmonise key regulatory issues, arbitrage opportunities persist today. A study published in November 2024 titled “Supervisory Cooperation and Regulatory Arbitrage”, using data gathered on 268 cooperation agreements between bank supervisors, revealed that such cooperation falls short of covering the global operations of large banking groups.
The study thus showed that this causes material regulatory arbitrage, with third countries often bearing the risks of this practice. “Banking groups allocate lending activities and risk into third-country subsidiaries when cooperation agreements cover their operations in other countries,” the paper concluded, revealing that the average distortion in a country’s foreign lending caused by regulatory arbitrage is 21 percent, with the effect being magnified in the presence of a weak supervisory framework. “Taken together, our results indicate that incompleteness in cooperation substantially diminishes its global effectiveness.”
Basel III, a comprehensive set of measures and reforms developed by the Basel Committee on Banking Supervision (BCBS) to strengthen the regulation, supervision and risk management of the banking sector, has helped to improve the resilience of the banking system following the Global Financial Crisis (GFC), particularly through higher capital and liquidity buffers. However, the new regulations’ reliance on risk-weighted assets (RWAs)—whereby risk weights are assigned to each of a bank’s assets to determine the minimum capital required to cover potential losses—has raised concerns about the potential for regulatory-arbitrage opportunities to arise.
For one, calculating RWAs largely remains an in-house process within banks. This raises the possibility that some banks may undervalue risk, thereby reducing their capital requirements excessively. Should all banks in a specific market conduct such inadequate risk assessments, the systemic risk across the market could well rise to an alarming level.
A 2017 study published in the Journal of Financial Stability sought to gauge RWA density by analysing the determinants of the ratio of RWAs to Exposure at Default (EAD)—that is, the expected amount a bank could lose if a borrower defaults on a loan—using data for 239 European banks between 2007 and 2013. The research found that regulatory arbitrage:
- was present among the banks;
- likely materialised via the manipulation of risk weights when employing Internal-Ratings-Based (IRB) models—risk-management models that allow banks to use their own internal data to calculate their regulatory-capital requirements;
- was stronger at banks using advanced IRB models than those using foundational IRB models.
“So, even with the sturdy armor of Basel II and Basel III, supervisors fret that banks could underreport their true risks. And the cruelty is that those suspected to underreport are the most sophisticated banks,” the authors concluded.
A more recent upgrade to the Basel III framework, known as Basel III Endgame, however, appears to have reduced the likelihood of banks exploiting regulatory arbitrage. According to Vincenzo Bavoso of the University of Manchester, three measures in particular are worth highlighting in this regard:
- the standardisation of operational RWAs, which is designed to further limit the use of internal models for the calculation of operational risk;
- the inclusion of cross-jurisdictional derivatives claims for the calculation of global systemically important banks’ (G-SIBs’) capital requirements, which could limit the extent to which derivatives can be employed for regulatory-arbitrage purposes;
- the significant increase in capital requirements for G-SIBs.
According to the BCBS’s chairperson and governor of the Sveriges Riksbank, Erik Thedéen, the implementation of Basel III means that banking regulators and market participants should push for greater convergence. “A level playing field is critical to preventing regulatory arbitrage, maintaining confidence in the international banking system and avoiding a dangerous deregulatory race to the bottom,” Thedéen wrote in an August 22 article for the Financial Times. “When regulators diverge, financial stability drifts. Fragmentation would be disruptive, reduce prosperity in good times and weaken our ability to respond during stress events.”
Is there an upside to regulatory arbitrage? Work by Thorsten Beck, director of the Florence School of Banking and Finance, found that countries with weaker regulatory standards may receive capital inflows that allow firms to borrow more, potentially alleviating financial constraints. That said, Beck also cautioned that such benefits would be conditional on whether the additional lending is targeted at “well-managed, efficient and profitable firms”, as purely risk-motivated funding might support undesirable projects with negative net present values (NPVs).
What’s more, a March 2025 paper by Thorsten Beck, Consuelo Silva-Buston and Wolf Wagner, published in the Review of Finance,showed that firms that borrow from banks that receive positive shocks from third-country supervisory cooperation expand their activities. This manifests through increased asset bases, higher capital expenditures and greater R&D (research and development) expenditures. Firms also see their profits increase.
“Overall, this points to positive real effects arising from regulatory arbitrage,” Beck recently confirmed. “In particular, the fact that the additional lending seems to be targeted at high-quality, safe firms, coupled with the fact that financial constraints are likely to be tighter in countries with weaker supervisory standards (and hence those receiving the inflows), allows the possibility that a reallocation of lending between countries overall alleviates financial constraints. So, clearly there is a bright side to regulatory arbitrage!”
That said, Beck also warned that such results do not suggest that regulatory arbitrage overall is desirable. “Instead, our results suggest that there are likely to be trade-offs between additional lending and financial stability.”
link