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	== See also ==		== See also ==
	* [[Financial Economics]]		* Financial Economics
	* [[Institutional Economics]]		* Institutional Economics
	* [[Banking]]		* Banking

	== References ==		== References ==

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'''Regulatory arbitrage''' is the practice of exploiting differences in the regulatory treatment of economically equivalent activities, in order to reduce the burden of regulation or to increase the profit. Regulatory arbitrage is a central issue in the design of financial regulation.

== Concept ==
Regulatory arbitrage arises when the same economic activity is treated differently by the regulations, so that firms have an incentive to conduct the activity in the form that is treated more favourably.

The differences may arise from the definition of the activities, from the rules that apply to different types of institution, or from the differences in the regulations across jurisdictions.

== Forms ==
Financial regulatory arbitrage takes several forms. Firms may conduct activities in the legal form that attracts the least regulation, for example by using a subsidiary or a special purpose entity that is subject to lighter rules.

Firms may also move activities to jurisdictions with lighter regulation, a process known as regulatory competition. The movement can undermine the effectiveness of the regulation in the home jurisdiction.

Firms may also exploit the differences in the treatment of economically equivalent instruments. The shift of activity to the instrument that is treated more favourably can undermine the intent of the regulation.

== Consequences ==
Regulatory arbitrage has consequences for the effectiveness of regulation and for financial stability. The arbitrage can shift activity to the parts of the system that are less regulated, which may increase the risk to the system.

The arbitrage can also create a race to the bottom, in which jurisdictions compete to attract activity by lowering their standards. The result may be a general weakening of the regulation.

The arbitrage complicates the measurement of risk, since the activities are conducted through entities and instruments that may not be captured by the regulatory data. The measurement of the risk of the system must therefore account for the arbitrage.

== Responses ==
The responses to regulatory arbitrage include the harmonisation of the rules across jurisdictions and across the types of institution, and the extension of the regulation to the activities that were previously unregulated.

The harmonisation is pursued through international cooperation, including the standards set by the international bodies. The standards provide a common framework, though the implementation varies across jurisdictions.

The design of the regulation must be robust to the arbitrage, which requires attention to the economic substance of the activities rather than to their legal form. The framework must be reviewed as the activities evolve, and it must address the new forms of arbitrage that emerge.

== The Shadow Banking System ==
The shadow banking system comprises the entities and the activities that provide the credit intermediation outside the regular banking system. The system includes the money market funds, the special purpose entities, and the other intermediaries.

The shadow banking system is a source of the regulatory arbitrage, since the activities can be conducted outside the regulatory perimeter. The system can therefore accumulate the risk without the oversight of the regulators.

The response includes the extension of the regulation to the activities and the strengthening of the monitoring of the system. The measurement of the size and of the risk of the system is a central task of the supervisors.

== The Basel Standards ==
The Basel standards are the international framework for the regulation of the banks, developed by the Basel Committee on Banking Supervision. The standards specify the capital and the liquidity requirements and the other prudential rules.

The standards are intended to provide the common framework across the jurisdictions and to reduce the scope for the regulatory arbitrage. The implementation varies across the jurisdictions, which creates the potential for the arbitrage.

The standards are based on the risk weights, which determine the capital that the banks must hold for each asset. The banks have the incentives to hold the assets with the lower risk weights, which can create the arbitrage if the weights do not reflect the risk accurately.

== The International Cooperation ==
The international cooperation is central to the response to the regulatory arbitrage. The cooperation includes the setting of the standards, the assessment of the compliance of the jurisdictions, and the sharing of the information among the supervisors.

The cooperation is pursued through the international bodies, including the Basel Committee and the Financial Stability Board. The bodies set the standards and monitor the implementation, and they provide the forum for the coordination of the policy.

The cooperation is subject to the limits, since the jurisdictions have the different interests and the different legal frameworks. The design of the framework must take account of these differences and must provide the incentives for the compliance.

== Summary ==
Regulatory arbitrage is the exploitation of the differences in the regulation, and it is a central issue in the design of the financial regulation. The responses, including the harmonisation of the rules and the international cooperation, inform the understanding of the governance of the financial system.

== See also ==
* [[Financial Economics]]
* [[Institutional Economics]]
* [[Banking]]

== References ==

<ref name="r1">Research on regulatory arbitrage and on its consequences.</ref>
<ref name="r2">Studies of international cooperation in financial regulation.</ref>
<ref name="r3">Analyses of the design of regulation that is robust to arbitrage.</ref>

<references />

[[Category:Financial economics]]
[[Category:Institutional economics]]
[[Category:Banking]]

Regulatory Arbitrage - Revision history

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