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

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.