On the subject of securitization and regulatory arbitrage, Daniel Tarullo notes:

"securitization appears to present a case in which efforts to plug gaps in regulatory coverage are quickly and repeatedly overtaken by innovative arbitraging measures."

Arnold Kling noted the problem of adaptation of economic agents to changes in the regulatory regime in his paper on the financial crisis:

"The lesson is that financial regulation is not like a math problem, where once you solve it the problem stays solved. Instead, a regulatory regime elicits responses from firms in the private sector. As financial institutions adapt to regulations, they seek to maximize returns within the regulatory constraints. This takes the institutions in the direction of constantly seeking to reduce the regulatory “tax” by pushing to amend rules and by coming up with practices that are within the letter of the rules but contrary to their spirit. This natural process of seeking to maximize profits places any regulatory regime under continual assault, so that over time the regime’s ability to prevent crises degrades."

Regulatory arbitrage follows from the application of Goodhart's Law to financial regulation. One of Daniel Tarullo's key recommendations to counter this arbitrage is the adoption of a "simple leverage ratio requirement" . Such blunt measures reduce efficiency - of course, we can make the system more resilient if we insist on blanket 25% bank capital ratios and ban all bonuses but this would be a grossly inefficient solution.

The tradeoff between efficiency and resilience is a constant theme in fields as diverse as corporate risk management, ecosystem management and in this case, financial regulation.


On The Futility of Banning Proprietary Risk-Taking By Banks at Macroeconomic Resilience

[...] good in theory but it’s almost impossible to enforce in practise. As I’ve discussed previously, a detailed and fine-tuned regulatory policy will be easy to arbitrage and a blunt policy will [...]