“Regulatory arbitrage, implicating the banking, shadow banking and the financial system. With a spotlight on the Australian financial policy landscape”

The insolvency of banks occurs from a drying up of credit. Consider the polar opposite, do banks that have 100 percent deposit insurance (DI), experience a lack of banking prudence, ill-discipline, biased advantage, opportunity for regulatory arbitrage? The answer is, yes! They do. Any business declares insolvency when their liabilities have exceeded their assets, and, as Goodhart (2008) (1) many people would support the unlimited shareholder liability precedent that was in action prior to regulatory interference in the late 1980’s. The key reasoning behind this stance is, that it requires no taxpayer recapitalisation.

Financial regulation has behavioural qualities that are worth discussing. Over regulating a sector, reduces profitability opportunities, thus, incumbents move their operations into un-regulated sectors. Capital requirement regulation, engenders regulatory arbitrage and spurs banking intermediaries to shift their playing field from the banking system into the shadow banking system (Goodhart et al. 2012) (2). Non-regulated sectors are affected first during an economic shock, case in point with SPE’s and conduits during the GFC (Goodhart 2010, p. 177) (3). The policy implication here is that there should be an allowance for failure in order to avoid the regulatory arbitrage that is brought about from over regulation.

Policy ramifications are not circumscribed to the US financial and banking sectors, but also ring true for the Australian economic landscape. Drawing upon the Financial System Enquiry Final Report (2014) (4) the rhetoric is consistent regarding; ineffective regulatory disclosure, removing explicit and implicit government guarantees, removal of barriers to international and domestic competition and ceasing to transfer banking risk to taxpayers by increasing capital requirements.

The policy implication in response, is that government guarantees introduce covert costs which limit efficiency and competition within the banking sector, and therefore, should be minimised in order to reinforce domestic and international confidence in Australia’s banking sector.

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References:

(1) Goodhart, C. 2008, ‘The regulatory response to the financial crisis’, Journal of Financial Stability, vol. 4, pp. 351-358.

(2) Goodhart, C., Kashyap, A., Dimitrios, P., Alexandros P. 2012, ‘Financial Regulation in General Equilibrium’, AXA Working Paper Series, no. 9, pp. 1-50.

(3) Goodhart, C. 2010, ‘The Future of Finance And the theory that underpins it’, The Future of Finance: The LSE Report, p. 177.

(4) Financial System Enquiry Final Report 2014, Financial System Enquiry Final Report, November 2014, The Australian Government the Treasury.