Bank Capital Structure and Financial Innovation: Antagonists or Two Sides of the Same Coin?

This article examines the challenges to banking capital regulation posed by ongoing financial innovation through regulatory capital arbitrage. On the one hand, such practice undermines the quality of regulatory capital, eroding prudential capital standards, but most importantly it creates a distortion in the regulatory capital ratio measures, which prevents investors and regulators from identifying the bank’s real underlying risks. Opportunities for regulatory capital arbitrage arise as a consequence of the inherent mismatch of accounting goals, corporate law and prudential regulation – all interacting with the notion of capital for banks. On the other hand, financial innovation is the result of banks’ risk-management policies. In order to reduce the cost of capital and compliance banks engage in derivatives, structured finance and hybrid instruments, altering the risk/return of their cash flow and the information released to the market for disclosure. In a way, regulation is the solution but also part of the problem. For this reason, new regulation strategies for banks need to be implemented. Systemic risk and balance-sheet risk need to be tackled respectively with macro- and micro-prudential regulation. This would involve an international harmonization of the accounting standards and individualised capital adequacy requirements for banks. The regulation has to be functional for the market under examination. The regulator should therefore consider the adoption of prudential filters to make static variables such as accounting rules, which are normally focused on evaluation, more dynamic to give banks some financial flexibility in their risk-management policies.