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Discussion Paper
Leverage Rule Arbitrage
Classic arbitrage involves the same asset selling at different prices; the leverage rule arbitrage we study here involves assets of different risk levels requiring the same amount of capital. The supplementary leverage ratio (SLR) rule, finalized by U.S. regulators in September 2014, requires a minimum ratio of capital to assets at the largest U.S. banks. The floor is higher for more systemically important banks, but not for banks with riskier assets. That non-risk-based aspect of SLR was intentional, since the leverage limit was meant to backstop (?supplement?) risk-based capital rules in ...
Report
Where Do Banks End and NBFIs Begin?
In recent years, assets of nonbank financial intermediaries (NBFIs) have grown significantly relative to those of banks. These two sectors are commonly viewed either as operating in parallel, performing different activities, or as substitutes, performing substantially similar activities, with banks inside and NBFIs outside the perimeter of banking regulation. We argue instead that NBFI and bank businesses and risks are so interwoven that they are better described as having transformed over time, rather than as having migrated from banks to NBFIs. These transformations are at least in part a ...
Working Paper
What we learn from China's rising shadow banking: exploring the nexus of monetary tightening and banks' role in entrusted lending
We argue that China's rising shadow banking was inextricably linked to potential balance-sheet risks in the banking system. We substantiate this argument with three didactic findings: (1) commercial banks in general were prone to engage in channeling risky entrusted loans; (2) shadow banking through entrusted lending masked small banks' exposure to balance-sheet risks; and (3) two well-intended regulations and institutional asymmetry between large and small banks combined to give small banks an incentive to exploit regulatory arbitrage by bringing off-balance-sheet risks into the balance ...
Report
Insurance Companies and the Growth of Corporate Loans' Securitization
Insurance companies nonupled their CLO investments in the post-crisis period. This growth has far outpaced that of loans and bonds and is characterized by a strong preference for mezzanine tranches over triple-A tranches. Conditional on capital charges, insurance companies invest more in bonds and CLO tranches with higher yields. Importantly, they prefer CLO tranches because these carry higher yields relative to bonds. Preferences increased following the 2010 capital regulatory reform, resulting in insurance companies holding 40 percent of outstanding mezzanine tranches. Insurance companies ...
Working Paper
Financing Modes and Lender Monitoring
Shadow banks are widely believed to be a creation of financial regulation and regulatory arbitrage. We show that bank and nonbank modes of financing can emerge endogenously in a simple borrower-lender framework absent regulatory arbitrage or policy interventions. The coexistence of banks and shadow banks in the absence of regulatory intervention speaks to the importance of shadow banks as alternative modes of financial intermediation. We explore the scope of regulation in determining the size and location of shadow banking, as opposed to how regulation can be designed to curtail shadow bank ...
Report
Bank leverage limits and regulatory arbitrage: new evidence on a recurring question
Banks are regulated more than most firms, making them good subjects to study regulatory arbitrage (avoidance). Their latest arbitrage opportunity may be the new leverage rule covering the largest U.S. banks; leverage rules require equal capital against assets with unequal risks, so banks can effectively relax the leverage constraint by increasing asset risk. Consistent with that conjecture, we find that banks covered by the new rule shifted to riskier, higher yielding securities relative to control banks. The shift began almost precisely when the rule was finalized in 2014, well before it ...
Working Paper
Macroprudential Policy with Leakages
The outreach of macroprudential policies is likely limited in practice by imperfect regulation enforcement, whether due to shadow banking, regulatory arbitrage, or other regulation circumvention schemes. We study how such concerns affect the design of optimal regulatory policy in a workhorse model in which pecuniary externalities call for macroprudential taxes on debt, but with the addition of a novel constraint that financial regulators lack the ability to enforce taxes on a subset of agents. While regulated agents reduce risk taking in response to debt taxes, unregulated agents react to the ...
Report
Shadow Insurance
Liabilities ceded by life insurers to shadow reinsurers (i.e., affiliated and less regulated off-balance-sheet entities) grew from $11 billion in 2002 to $364 billion in 2012. Life insurers using shadow insurance, which capture half of the market share, ceded 25 cents of every dollar insured to shadow reinsurers in 2012, up from 2 cents in 2002. Our adjustment for shadow insurance reduces risk-based capital by 53 percentage points (or 3 rating notches) and raises default probabilities by a factor of 3.5. We develop a structural model of the life insurance industry and estimate the impact of ...
Discussion Paper
Leverage Ratio Arbitrage All Over Again
Leverage limits as a form of capital regulation have a well-known, potential bug: If banks can’t lever returns as desired, they can boost returns on equity by shifting toward riskier, higher yielding assets. That reach for yield is the leverage rule “arbitrage.” But would banks do that? In a previous post, we discussed evidence from our working paper that banks did do just that in response to the new leverage rule that took effect in 2018. This post discusses new findings in our revised paper on when and how banks arbitraged.
Discussion Paper
Insurance Companies and the Growth of Corporate Loan Securitization
Collateralized loan obligation (CLO) issuances in the United States increased by a factor of thirteen between 2009 and 2019, with the volume of outstanding CLOs more than doubling to approach $647 billion by the end of that period. While researchers and policy makers have been investigating the impact of this growth on the cost and riskiness of corporate loans and the potential implications for financial stability, less attention has been paid to the drivers of this phenomenon. In this post, which is based on our recent paper, we shed light on the role that insurance companies have played in ...