Why simple and robust regulation is the way to reduce financial complexity

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In 1997 the late Robin Potts was asked by the International Swaps and Derivatives Association to review the new market in credit default swaps. Potts, a leading company law advocate, drew attention to the famous case of Carlill v Carbolic Smoke Ball Company. A century earlier, a race-going judge, Sir Henry Hawkins, had defined a wager as “a contract by which two persons, professing to hold opposite views touching the issue of a future uncertain event, mutually agree that dependent on the determination of that event one shall win from the other”.

Insurance is, in Potts’ less felicitous words, “a contract to indemnify the insured in respect of some interest which he has against the perils which he contemplates he will be liable to”. He delivered the answer ISDA hoped and expected: credit default swaps were neither insurance (which would have been taxed and regulated as insurance policies) nor wagers (that would have been taxed and regulated as bets). Potts deftly avoided a difficult issue: if credit default swaps were neither wagers nor insurance contracts, what were they? What was the purpose of the transaction?

In 1997 there was an answer to this question, although not one on which Potts chose to dwell. Much of the complexity of modern finance is the result of regulatory arbitrage – avoiding or minimising restrictions by engaging in a transaction with more or less identical effect but more favourable regulatory treatment.

The initial purpose of the credit default swap was to exploit differential regulation of banks and insurers. Banks were required to hold reserves against loans calculated as a proportion of the amount of the loan. Insurers were required to hold reserves calculated as a proportion of the expected losses on the policies. ExxonMobil was a corporate borrower – and loans to companies carried a high risk weight in computing the reserves of banks. But it was also an extremely safe credit, so that the expected loss on the loan was negligible. Hence there was scope for profitable trade between bank and insurance company.

Even after Potts’ opinion, doubts remained as to the legality of such transactions by US residents. These were settled by the Commodity Futures Modernization Act of 2000, promoted by then Fed chairman Alan Greenspan and Treasury secretary Lawrence Summers. The explosive growth of credit default swaps, which were at the centre of the financial crisis, followed. Credit default swaps extended far beyond loans to ExxonMobil. When in 2006 Goldman Sachs sold securities linked to subprime mortgages, which the hedge fund manager John Paulson expected to fail, all parties in the transaction were engaged in what Hawkins had described as “a wager”.

The usual response to regulatory arbitrage is to elaborate the regulation. Thus begins a game of cat and mouse, in which financial companies are generally one or more steps ahead of the regulator. The familiar outcome is regulation, which becomes progressively more complex but less effective.

From the perspective of the non-financial economy, resources devoted to arbitrage are a dispiriting waste. Some of the cleverest minds in the country are devoted to activities that are actively damaging the goals of effective regulation and honest and transparent accounting. Arbitrage is a significant contributor to the trading profits of financial institutions.

Regulatory arbitrage is an inevitable outcome of the detailed prescriptive regulation of financial services. The only means of avoiding it is to ensure that transactions with similar economic effect are always treated in the same way. This is a generally accepted objective, but not realistically achievable in the context of the complexity of the current financial and regulatory system.

Many regulators still cling to the hope that regulatory arbitrage could be eliminated if only rules were sufficiently extensive and sufficiently carefully prescribed. But this is an illusion. One remedy is to allow regulators more discretion, so that they feel confident in implementing the spirit rather than the letter of the rules. But this would require a dramatic and permanent shift in both the calibre of regulatory staff, and the balance of political influence between regulators and those who engage in regulated activities. The better response is to find simpler and more robust principles of regulation.

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