The Ultimate Form of Regulatory Arbitrage

Gillian Tett has the latest perspective on a curious deal that Barclays (NYSE:BCS) did earlier this week (hat tip Brad DeLong). The deal goes something like this. Two former Barclays execs are starting a fund called Protium Finance. Protium has two equity investors who are putting in $450 million. Barclays is lending Protium $12.6 billion. Protium is using the cash to buy $12.3 billion in what we used to call toxic assets from Barclays. Protium’s 45 staff members get a management fee of $40 million per year (presumably from the equity investors, although that seems steep). Returns from the investments will be paid as follows, in this order (and this is important): (1) fund management fees; (2) a guaranteed 7% return to investors; (3) repayment of the Barclays loan; and (4) residual cash flows to the investors.

Barclays emphasized that it was not participating in regulatory arbitrage, because it is keeping the toxic assets on its balance sheet for regulatory purposes. That is, because it has a lot of exposure to those assets through its huge loan, it will continue to hold capital against those assets. So far so good.

But regulatory capital arbitrage is only one kind of arbitrage. For ordinary accounting purposes, the toxic assets are not on its balance sheet. So if they fall in value, Barclays will not have to recognize a loss – at least not until Protium defaults on its loan, which could be as far as ten years in the future. So the bank has the same true economic exposure, but can pretend it isn’t there for a long time.

Or does it have the same true economic exposure? If things go badly, yes, since Protium will default on the loan. If things go well, however, Protium’s investors get all the upside since they get the residual cash flows after the loan is paid off. So Barclays is left with all the downside and none of the upside. In return for giving away the upside, they should have gotten a good interest rate on the loan. The interest rate is LIBOR + 275 bp, and I have no way of calculating if that’s a good rate or not. But even assuming it is a good interest rate, this is what Nassim Taleb calls a nickels strategy – picking up nickels (the nice interest rate) in front of a steamroller (the risk of the assets falling in value).

Finally, we have the other kind of arbitrage. Although Barclays is recognizing its exposure to Protium, Protium is a different company, and it’s not a bank. That’s important these days, and this is Tett’s main point. In particular, because it’s not a bank, British regulators can’t do anything to it. In particular, they can’t prevent Protium from paying its managers whatever they want to pay it, and they probably can’t force Protium to even tell them what its managers are making.

So here we have the ultimate form of regulatory arbitrage. If you’re a bank exec worried about public exposure or, even worse, regulation of your compensation, go create a new special-purpose vehicle to manage bank assets, entice the equity investors in with a sweetheart deal, and pay yourself whatever you want. Given the size of Barclays, the shareholders won’t notice $40 million here or there, especially if it looks like it’s coming from someone else. Everyone wins.

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