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29 Cato J. 65 (2009)
Financial Innovation, Regulation, and Reform

handle is hein.journals/catoj29 and id is 67 raw text is: FINANCIAL INNOVATION, REGULATION, AND REFORM Charles W Calomiris Financial innovations often respond to regulation by sidestepping regulatory restrictions that would otherwise limit activities in which people wish to engage. Securitization of loans (e.g., credit card receiv- ables, or subprime residential mortgages) is often portrayed, correctly, as having arisen in part as a means of arbitraging regulatory capital requirements by booking assets off the balance sheets of regulated banks. Originators of the loans were able to maintain lower equity cap- ital against those loans than they otherwise would have needed to maintain if the loans had been placed on their balance sheets.' Capital regulation of securitization invited this form of off-bal- ance-sheet regulatory arbitrage, and did so quite consciously. Several of the capital requirement rules for the treatment of securitized assets originated by banks, and for the debts issued by those conduits and held or guaranteed by banks, were specifically and consciously designed to permit banks to allocate less capital against their risks Cato Journal, Vol. 29, No. 1 (Winter 2009). Copyright @ Cato Institute. All tights reserved. Charles W Calomiris is the Henry Kaufman Professor of Financial Institutions at Columbia University. He thanks Richard Herring, Charles Plosser, and Peter Wallison for helpful discussions. 'Financial innovations involving regulatory arbitrage can be complex. Securitized assets implicitly often remain connected to the balance sheet of the bank that origi- nated them despite the fact that the liabilities issued by the securitization conduits are not legally protected by the originating bank; lenders not only provide explicit credit enhancements to their off-balance sheet conduits, they also offer implicit guarantees to the market, which are valued by the market, which expects origina- tors to voluntarily stand behind the securitized debts of their off-balance sheet con- duits, at least under most circumstances (this phenomenon is known as implicit recourse-see Calomiris and Mason 2004). 65

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