When a bank falls, taxpayers may be on the hook to pick it up.
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A new Federal Reserve Bank of New York staff report, Regulatory Arbitrage Within the Firm by Dr. Nicola Cetorelli and Assistant Professor Shohini Kundu, delivers a sobering assessment of how banks have navigated post-2008 regulations. The authors examine how Large Bank Holding Companies (BHCs)—conglomerates that own both heavily regulated commercial banks and lightly regulated nonbank affiliates—manage capital internally.
Key Findings: Shifting the Safety Net
The research uncovers an internal shell game involving capital, a dynamic the authors suggest was driven by stricter regulatory requirements.
- The Basel III Response: As stricter Basel III capital requirements phased in starting in 2015, BHCs faced intense pressure to bolster their commercial bank subsidiaries. Rather than raising costly external equity, parent companies siphoned capital from their nonbank affiliates and transferred it into their banking units. Regulators did not require banks to raise high-quality capital from outside investors.
- The “Safer” Bank Illusion: Fueled by these internal equity infusions, bank subsidiaries accumulated 5 to 8 percentage points more excess capital than comparable standalone banks without nonbank siblings.
- The Trade-Off: While the bank units appeared rock-solid, the nonbank affiliates deteriorated. Their capital ratios plunged, credit quality worsened, and they pivoted aggressively toward riskier consumer lending to compensate for the capital drain.
- Zero Net Change: At the consolidated group level, total equity, total assets, and overall lending remained flat. Risk was not eliminated; it was merely relocated to a different corner of the corporate structure.
Dr. Nicola Cetorelli
FRBNY
Implications for the Banking System: Hidden Fragility
The core implication is that the post-crisis banking system is not as safe as its balance sheets suggest.
- Overstated Safety: Regulators reviewing commercial bank balance sheets see healthy capital buffers. However, this safety is a mirage because it ignores the structural decay occurring next door within the same parent company.
- The Chain Reaction Risk: The consolidated parent organization remains deeply exposed to its weakened nonbank affiliates. If those arms suffer heavy losses, the parent faces an implicit obligation to rescue them to protect its reputation and operational viability.
- The Stress Test Shock: The authors simulated a crisis using 2008-scale losses on nonbank assets. They found that if parent organizations were forced to bail out distressed nonbank affiliates, 4 to 6 percent of all Bank Holding Companies would completely exhaust their capital buffers, pushing them to the brink of failure.
Assistant Professor Shohini Kundu
UCLA Anderson
What Bank Regulators Should Do
Cetorelli and Kundu emphasize that organizational structure fundamentally determines whether regulation succeeds or fails. Far from the time to deregulate, the findings argue for closing existing loopholes. Regulators must change how they measure and enforce safety standards:
- Adopt True Consolidated Supervision: Regulators cannot assess commercial banks in isolation. They must evaluate the financial health, capital adequacy, and risk profile of the entire holding company holistically, actively penalizing internal capital shifting.
- Account for Implicit Liabilities: When assessing a bank’s capital buffers, regulators must factor in the “shadow” risk of its affiliates. If a bank has a heavily leveraged, under-capitalized nonbank sibling, its required capital buffer should be higher to account for a potential emergency bailout.
- Close Asymmetric Loopholes: The root cause of this behavior is that prudential regulations bind asymmetrically—stricter for banks, looser for nonbanks. Regulators need to harmonize rules for entities under the same corporate umbrella so that internal capital markets cannot be exploited for regulatory arbitrage.
Until regulators address these structural flaws, the game of capital musical chairs will persist. When the next bank falters, taxpayers should not be left to shoulder the cost.
