Define regulatory arbitrage. Briefly discuss the new capital buffer requirements proposed under Basel 3. Regulatory Arbitrage
This is a practice whereby firms capitalize on loopholes in regulatory systems in order to circumvent unfavourable/unprofitable regulation. Arbitrage opportunities may be accomplished by a variety of tactics, including restructuring transactions, financial engineering and geographic relocation. For example, a company may relocate its headquarters to a country with lower tax rules and favourable regulatory policies to save cost and increase profit. Regulatory arbitrage is difficult to prevent entirely, but its prevalence can be limited by closing the most obvious loopholes and thus increasing the costs associated of circumventing the regulation.
Basel III guidelines are aimed at to improve the ability of banks to withstand periods of economic and financial stress as the new guidelines are more stringent for requirements for capital adequacy, stress testing and market liquidity in the banking sector than Basel1 and 2. The new capital requirements are as follows: New Capital Conservation Buffer
This conservation capital buffer will be used to absorb losses during periods of financial and economic stress. Banks will be required to hold a capital conservation buffer of 2.5% to withstand future periods of stress bringing the total common equity requirement to 7% (4.5% common equity requirement and the 2.5% capital conservation buffer).The capital conservation buffer must be met exclusively with common equity. While banks are allowed to draw on the buffer during periods of stress, the closer their regulatory capital ratios approach the minimum requirement, the greater the constraints on earnings distributions.Banks that do not maintain the capital conservation buffer will face restrictions on payouts of dividends, share buybacks and bonuses.
Countercyclical Capital Buffer
A countercyclical buffer within a range of 0% - 2.5% of common...
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