Why Do Banks Practice Regulatory Arbitrage? Evidence from Usage of Trust Preferred Securities

Working Paper No. 19984 We propose a theory of regulatory arbitrage by banks and test it using trust preferred securities (TPS) issuance. From 1996 to 2007, U.S. banks in the aggregate increased their regulatory capital through issuance of TPS while their net issuance of common stock was negative du...

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Bibliographic Details
Published in:NBER Working Paper Series 2014-03, p.19984
Main Authors: Boyson, Nicole, Fahlenbrach, Rüdiger, Stulz, René M
Format: Article
Language:English
Subjects:
Arbitrage
Bank holding companies
Banking industry
Business models
Capital requirements
Capital structure
Economic theory
Equity
Financial institutions
Regulation of financial institutions
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Summary:Working Paper No. 19984 We propose a theory of regulatory arbitrage by banks and test it using trust preferred securities (TPS) issuance. From 1996 to 2007, U.S. banks in the aggregate increased their regulatory capital through issuance of TPS while their net issuance of common stock was negative due to repurchases. We assume that, in the absence of capital requirements, a bank has an optimal capital structure that depends on its business model. Capital requirements can impose constraints on bank decisions. If a bank's optimal capital structure also meets regulatory capital requirements with a sufficient buffer, the bank is unconstrained by these requirements. We expect that unconstrained banks will not issue TPS, that constrained banks will issue TPS and engage in other forms of regulatory arbitrage, and that banks with TPS will be riskier than other banks with the same amount of regulatory capital, and therefore, more adversely affected by the credit crisis. Our empirical evidence supports these predictions.
ISSN:0898-2937
DOI:10.3386/w19984