New on FinoLib · Volume II: Capital Markets
I have just published a new article on FinoLib, my free finance education library: Three Lines of Defense Model and Regulatory Arbitrage. It is part of Volume II: Capital Markets. Below is a summary of the topic in plain, expert language, so you can follow the idea even before you open the full article.
9.5 Why Regulatory Arbitrage Happens
The idea in plain words
Regulatory arbitrage means putting an activity where the rules are lightest, even though the economic risk is the same. It pays most with capital rules, because holding less capital frees up money to lend. Basel III answers with layered measures, each closing a known game: a 4.5% CET1 minimum plus a 2.5% buffer, a 100% liquidity coverage ratio and net stable funding ratio, a leverage ratio and a 72.5% output floor.
Key points
■A bank under Basel rules as the EU applies them, with $12 billion of CET1 on $120 billion of modeled RWA, has a 10.0% ratio and $3.6 billion of loss before payout limits start.
■The minimum is breached at a $6.6 billion loss; at $4 billion, payouts are capped at 60%.
■If models cut RWA to $100 billion, the output floor resets it to $116 billion, adding $1.12 billion to required capital; US rules have no such floor and would rate this bank on standardized RWA at 12 ÷ 160 =…
A closer look
Regulatory arbitrage is the practice of structuring a business, a transaction, or an entire operation specifically to take advantage of differences between regulatory regimes — locating a trading desk, a legal entity, or a fund structure in whichever jurisdiction imposes the lightest capital, compliance, or tax burden for a given activity. This is a direct, largely unavoidable consequence of the absence of one single global financial regulator: as long as meaningfully different rules exist across borders for economically similar activity, some participants will rationally locate that activity where the rules are least burdensome.
Decision rule
A reading rule for any structure sold on capital relief: if a guarantee, liquidity line or reputational promise keeps the loss with you, the risk has not moved, so hold capital as if the asset were still on the books. Read a CET1 ratio only with its RWA method, floor position and dollar headroom: in the example the real cushion is $3.6 billion of loss, not the 10% headline. The rule does not apply to sales without recourse, which move the risk itself.
The costliest mistake
Planning distributions on modeled RWA that the floor overrides. Under the Basel floor, a bank that tunes its models to $100 billion of RWA plans to hold 7% × 100 = $7.0 billion of CET1, but the floored requirement is 7% × 116 = $8.12 billion: a $1.12 billion gap that comes out of buybacks and dividends or forces new equity. Plan on the higher of modeled and floored RWA; in the US, plan on standardized RWA, because the reported ratio is the lower of the two.
9.6 The Three Lines of Defense & Risk Governance in Practice
The idea in plain words
The Three Lines of Defense divide the job of managing risk. The first line is the business, which owns the risk. The second line, risk and compliance, oversees and challenges it. The third line, internal audit, gives independent assurance. It works only when the second and third lines are truly independent in reporting line, pay and standing, and when a breach of limits forces action rather than another report.
Key points
■The IIA renamed it the Three Lines Model in July 2020.
■US heightened standards give the chief risk executive unrestricted access to the board at banks of $50 billion or more.
■Credit Suisse saw Archegos at 26.5 times its limit ($530 million vs $20 million) in August 2020 and later lost about $5.5 billion.
Decision rule
Treat any limit excess as an event with an owner and a deadline, not a number in a report. If exposure exceeds a limit and is not back inside it, or covered by a documented, time-bound approval from the 2nd line, within the period your policy sets (days, not months), escalate to the chief risk officer; if it persists, to the board risk committee. Never cure a breach by raising the limit without a fresh, independent risk assessment.
The costliest mistake
Recording a breach instead of resolving it. Credit Suisse’s own systems showed Archegos at 26.5 times its limit seven months before the default; the cost of not acting was about $5.5 billion of loss plus about $387 million of fines, paid after UBS had taken the bank over in 2023. The fix is mechanical: every excess generates a ticket with an owner, a cure date and automatic escalation when the date passes.
What the full article covers
In the full article I take you through these sections:
■9.5 Why Regulatory Arbitrage Happens
■9.6 The Three Lines of Defense & Risk Governance in Practice
It includes worked examples, a look under the hood at the mechanics, a clear decision rule, the one mistake that costs people the most, a recap, a reveal-on-click quiz and the official sources behind every figure.
Volume II: Capital Markets
Read the full article on FinoLib
The complete article, Three Lines of Defense Model and Regulatory Arbitrage, with every worked example, diagram, quiz and source, is free to read in Volume II, Capital Markets on finolib.com.
Explore the Finance Education Series: Vol. II — Capital Markets · Vol. I — Global Economy · Vol. III — Finance Encyclopedia · Vol. IV — Finance Careers · Vol. V — Personal Finance