Regulatory arbitrage occurs when the difference in regulation is considered as a strong motivation for opening a branch in a country with less regulation (Karolyi & Tabaoda, 2012).
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Less regulation is the first level of inducement. Scholars have labeled the aspect of increasing a firm’s activities in countries with less regulation as the ‘race-to-the-bottom’. Houston, Lin & Ma (2009) present strong evidence that indicates that banks with headquarters in countries with stricter regulations are likely to set up subsidiaries in countries with less strict regulations.
Other incentives include increasing shareholder value by engaging in activities that increase profitability, or reduce operating costs. Regulatory arbitrage that increases shareholder value by seeking lower costs is acceptable. Karolyi & Tabaoda (2012) call it benign regulatory arbitrage. There are firms that may want to conceal their poor performance (Karolyi & Tabaoda, 2012). Houston, Liu & Ma (2009) discuss that firms that engage in increased lending, through regulatory arbitrage, expose all jurisdictions to their risk taking.
Financial institutions rely on credit ratings on individual securities to assign them weights. Kwak (2009) discusses that a bank that has multiple levels of securities can get higher ratings for the derivatives, which allows them to use lower risk weights. The amount of capital that they are supposed to hold depends on the weights. Derivatives are securities developed from other assets such as bonds or real estate. Financial institutions that issue credit rely on credit ratings to assign weights on securities.
When the ratings are high, which indicate lower risk, they keep a small percentage of the credit they have issued as reserves. Kwak (2009) explains that holding a small percentage as capital increases risk for creditors because for a small drop in the prices of the securities, the financial institution may show signs of defaulting. Elliot & Treanor (2013) explain that “many banks were dependent on being able to roll over short-term liquidity, and we could see the parcel of unencumbered assets being used as collateral getting smaller” (para. 20).
Kwak (2009) discusses that there is a large number of the types of securities, which makes setting rules on capital requirements to be challenging. The requirements may be easily maneuvered.
The Basel II requirements have been blamed for providing a loophole on which securities ratings may increase susceptibility. Kwak (2009) explains that Basel II requirements make it possible to rely on historical data to rate securities. The subprime loans hardly defaulted which gave financial institutions a right to keep very small proportions of capital on the credit they had issued. Based on the Basel II requirements, lenders could have their securities highly rated because they were backed by returns from mortgages.
Lehman engaged in regulatory arbitrage because they targeted the lighter regulations in the U.K. to get approval for their transaction, which would not have been approved in the U.S. (Kakani, Singhania & Stack, 2012). Regulatory arbitrage is defined by taking advantage of less regulation in a foreign country to increase financial activities.
Kakani, Singhania & Stack (2012) explain that “the Repo 105 transactions were executed by Lehman Brothers International so that they could be under British jurisdiction” (p. 4). The approval they got from a law firm in Britain made investors have confidence in the transaction, and avoid much scrutiny.
On the American side, attorneys would not approve the transaction as a true sale. It would make investors doubt the nature of the transaction, and the financial position of the company. Lehman Brothers used their subsidiary in Britain to build investor confidence that would have been difficult in America.
Regulators in America would have cast a doubt on the size, and frequency of the transactions. However, the transactions meet all requirements to be recorded as true sales under SFAS 140 (Kakani, Singhania & Stack, 2012). More scrutiny in America from regulators, analysts, auditors and attorneys would have created doubt on the authenticity of the sales.
Lehman relied directly on attorneys, and auditors for approval. Once a reputable law firm and a reputable auditing firm had approved the transactions as true sales, investors were likely to endorse the transactions as sales. Kakani, Singhania & Stack (2012) discuss that “they got approval from a reputable British law firm, Link laters LLP” (p. 4). Ernst & Young is a reputable auditing firm that they sought to give assurance to investors that they are abiding to SFAS.
The transactions meet the standards to be recorded as sales, only that they appear intentionally carried out to reduce assets and liabilities. It may appear that the auditors advised the company to lower their liabilities, but within SFAS. The transfers give an interest range of $5 for $100 which is above the 2% range required by SFAS for a repurchase agreement.
Doubt may be cast on whether they ceased to control the assets, whether Hudson Castle could resell, or pledge the assets to other lenders. It appears that Lehman Brothers transactions met one of the standards, and purported to have met the other two as discussed by Kakani, Singhania & Stack (2012).
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Lehman relied directly on a frequent buyer, who purchases when needed. It relied on Hudson Castle Group, an affiliate company to be a frequent buyer (Kakani, Singhania & Stack, 2012).
Lehman indirectly relied on approval from analysts, credit raters, and regulators. Sometimes analysts look at the size of the company, and assume that it is safe. Karolyi & Tabaoda (2012) explain that the perception that a company is large and profitable may give the impression that it has nothing to hide.
Analysts may give approval based on the company’s financial history. Lehman was approved by analysts because it had a large worth of assets. When investors tried to compare it with the fall of Bear Stearns, which had collapsed in the first quarter 2008, analysts mentioned the worth of Lehman’s assets (AP, 2008).
Credit raters use historical trends to rate securities. When Lehman’s mortgage-backed securities were rated as safe, they could keep less capital. They could create more credit from the money they received from investors. Karolyi & Tabaoda (2012) explain that having less capital increases the risk taken by lending institutions.
Regulators are supposed to check that a company has met the industry standards. Kakani, Singhania & Stack (2012) discuss that the SEC would have approved the transactions because they were legal. However, regulators may need to check the frequency of the transaction, and the size of the transfer. The frequency of the transactions was alarming.
Kakani, Singhania & Stack (2012) discuss that Lehman engaged in Repo 105 at the end of the fourth quarter of 2007 worth $39 billion, and two others in the following two quarters worth $49 billion and $50 billion. The high frequency and the short-period in which the transfers were reversed is enough to make regulators conduct a review. Regulators are required by law to protect investors by making companies give their actual financial position.
In Lehman’s case, regulators knew the risk that investors were exposed to by such transactions, but they left it happen because it met the minimum requirements of SFAS 140. Elliot & Treanor (2013) blame regulators for allowing over-leverage by financial institutions. Moreover, the transactions were carried out in a foreign country where regulators are less strict than in the U.S.
AP. (2008,). Lehman Brothers Fuels Wall Street Confidence Crisis. Web.
Elliot, L., & Treanor, J. (2013). Lehman Brothers collapse, five years on: ‘We had almost no control’. Web.
Houston, F.J., Lin, C., Ma, Y. (2009). Regulatory arbitrage and international bank flows. Web.
Kakani, K.R., Singhania, V., & Stack, M. (2012). Lehman Brothers’ fall. Ontario: Ivey Publishing.
Karolyi, A.G., & Tabaoda, G.A. (2012). The role of regulation in cross-border bank acquisitions: Is it really a ‘race to the bottom’? Web.
Kwak, J. (2009). The Baseline Scenario: Regulatory capital arbitrage for beginners. Web.