Crowded trades in capital arb August 20, 2010 at 6:06 am

The Streetwise Professor points out something that I had not realised about regulatory capital arbitrage: not only do regulatory capital arbitrage opportunities blunt the impact of regulation, but they also produce crowded trades. By definition all the banks who engage in these trades are one way round, while all their counterparties are the other. This kind of situation often ends badly, so it does encourage me to renew my call for supervisors to set up Regulatory Capital Arbitrage groups to look at these opportunities. The only difficulty would be to stop the good ones turning themselves into hedge funds…

6 Responses to “Crowded trades in capital arb”

  1. […] Crowded trades in capital arb Deus Ex Macchiato […]

  2. reg arb is a classic case of un-intended consequences. You rightly identify the risks. By seeking to mitigate risk under a unified approach, gaming the risk system becomes more appealing, inducing more oblique and hidden but potentially as devastating risks.

    I would gladly trade uncertain actors with risk premiums and loosely coupled systemic inefficiency versus the false certainty of a tightly regulated and tightly coupled regime which may force all actors to converged views and actions in a crisis.

  3. Nick – indeed. The key point being ‘loosely coupled’. The problem with detailed capital rules which are the same for all is that they have the side effect of increasing coupling.

  4. […] been an interesting dialogue between Streetwise Professor and Deus ex Macchiato on the matter of the practical impact of the pending Basel III rules, which will rejigger, in a […]

  5. […] Smith at Naked Capitalism was kind enough to refer to some remarks I and the Streetwise Professor had made about Basel III. That got me thinking about what you can hope […]

  6. […] is flattering to know that the always insightful (and knowledgeable) David at Deus ex Macchiato found insightful my observation that capital requirements can result in crowded trades–and hence systemic […]