The recourse rule, regulatory arbitrage, and the financial crisis

In November 2001, regulators finalized the “Recourse Rule.” The rule lowered risk weights, and therefore commercial bank holding company capital requirements, to 0.2 for holdings of AAA- and AA-rated “private label” securitization tranches, created by investment banks and securitizing commercial bank holding company subsidiaries; risk weights for A-rated holdings equaled 0.5. The rule’s aim was to encourage securitization, but not risk-taking. Regulators indicated that the rule would apply to larger holding companies, without identifying them. Using bank holding companies with subsidiaries that commented on the proposed rule-makings as a treatment variable, average treatment effects from a fully flexible difference-in-differences model indicate that treated banks increased their holdings of the highly rated tranches relative to total assets, while other holding companies, on average, did not. Holding companies with greater highly rated tranche holdings also experienced greater increases in risk after Q1 2008, which suggests that poor performance may have been unanticipated.