Bank Capital Structure and Financial Innovation: Antagonists or Two Sides of the Same Coin?

Abstract

This article examines the challenges to banking capital regulation posed by ongoing financial innovation through regulatory capital arbitrage (RCA). On the one hand, such practice undermines the quality of regulatory capital, eroding prudential capital standards, but most importantly it creates a distortion in the regulatory capital ratio measures, which prevents investors and regulators from identifying the bank’s real underlying risks. Opportunities for RCA arise as a consequence of the inherent mismatch of accounting goals, corporate law, and prudential regulation—all interacting with the notion of capital for banks. On the other hand, financial innovation is the result of banks’ risk-management policies. In order to reduce the cost of capital and compliance, banks engage in derivatives, structured finance, and hybrid instruments, thus altering the risk/return of their cash flow and the information released to the market for disclosure. In a way, regulation is the solution but also part of the problem. Implementing too severe rules for capital and disclosure, as well as fair value measurement for financial reporting purposes, may result in strengthening regulatory capital standards and limiting the opportunities for arbitrage at the expense of constraining banks’ risk-management policies. To validate this hypothesis, the article examines three problematic areas for capital micro-prudential regulation: hybrid instruments and structured finance, assets valuation and provisioning, and disclosure. The analysis is integrated with an assessment of the same issues from the perspective of macro-prudential regulation. In relation to these areas, the article discusses the regulator’s approach and regulatory strategies implemented. Macro-prudential regulation is essential to reduce RCA. Basel III has created regulation based on a multiple metric system supported by a strengthened risk-weight capital ratio and a comprehensive legal framework for supervisor and resolution. While these legal frameworks provide constraints that mutually reinforce prudent behaviour, it is important to point out that the regulation has to be functional for the market under examination in order to strike the right balance between regulatory flexibility and robust, enforceable standards.