Financial Innovation, Regulation, and Reform

Financial innovations often respond to regulation by sidestepping regulatory restrictions that would otherwise limit activities in which people wish to engage. Securitization of loans (e.g., credit card receiv-ables, or subprime residential mortgages) is often portrayed, correctly, as having arisen in part as a means of “arbitraging ” regulatory capital requirements by booking assets off the balance sheets of regulated banks. Originators of the loans were able to maintain lower equity cap-ital against those loans than they otherwise would have needed to maintain if the loans had been placed on their balance sheets.1 Capital regulation of securitization invited this form of off-bal-ance-sheet regulatory arbitrage, and did so quite consciously. Several of the capital requirement rules for the treatment of securitized assets originated by banks, and for the debts issued by those conduits and held or guaranteed by banks, were specifically and consciously designed to permit banks to allocate less capital against their risks