What is Regulatory Arbitrage?

Regulatory arbitrage is the process by which investors or institutions such as banks attempt to benefit from inconsistent financial regulations. These inconsistencies may be caused by the way different financial firms are regulated or due to contrasting laws in multiple countries. The idea behind regulatory arbitrage is to keep the basic substance of a business deal intact while avoiding any regulatory obstacles that otherwise might mitigate the profits being made. This is a controversial practice and has been linked to far-reaching economic problems in countries throughout the world.

Although worldwide financial collapses at the start of the 21st century led to increased demands for transparency among large financial institutions, the reality is that there still exists the opportunities for these large firms to profit from regulatory loopholes. Experienced employees at such large firms have the ability to make certain financial transactions appear as if they are completely obeying binding regulations, when in fact they are often pushing the boundaries of the law or even overstepping them. The practice of regulatory arbitrage is a hugely profitable one, even though it sometimes puts the greater economic picture in severe jeopardy.

One way that regulatory arbitrage is achieved is through regulatory inconsistencies in how certain financial institutions are viewed. Banks, for example, are required to have enough assets to cover the risks involved with the investments they make. On the other hand, institutional investors, insurance companies, and other major financial forces don't have quite the same restrictions. A bank could transfer risk to one of these institutions to meet its requirements, but the risk still exists.

International efforts to install financial regulations that are binding to all nations of the world have not completely come to fruition. As a result, a set of regulations that binds an investment firm in one country may not exist in another. To take advantage of this, large companies tend to make transactions wherever the laws allow them to thrive, which is another form of regulatory arbitrage.

Since regulatory arbitrage can exist in many forms, it is hard to spot and even harder to prevent. In some cases, as in credit default swaps that helped to bankrupt huge financial institutions in the first decade of the 21st century, these practices have been exceedingly harmful. What generally happens is that the downfall of major financial institutions trickles down and damages the economic situations of the citizens those institutions serve. For this reason, such arbitrage must be monitored as much as possible by lawmakers to prevent such catastrophic financial events from occurring.