What Is Regulatory Arbitrage

In economic practice there is such a thing as regulatory arbitrage, which should be understood as income or cost arising from the actions of regulators. For example, thanks to the recycling fee, our domestic manufacturers earn additional income, because the cost of imported cars rises by the amount of that charge. Or the government bans the export of raw materials, and processors gain a regulatory arbitrage because the raw materials become cheaper. In general, such measures are aimed at supporting domestic industry, which is, of course, highly debatable, but there is nonetheless a certain logic to it.

The banking sector also has many regulatory arbitrages, which not only harm the economy but also allow the banking sector as a whole to make money without much effort. Thus, the banking sector's total pre-tax profit for 2023 amounted to about KZT 2.5 trillion, of which regulatory arbitrage accounted for about KZT 0.9 trillion, or 36%.

Quite a lot, you must agree. This is money that banks earned solely because of the regulator's restrictions on certain things. Let me give some examples:

The ban on paying interest on current accounts. By my estimates, this rule earned banks about KZT 770 billion in total. Yet it is an artificial barrier between the owners of money and risk-free financial instruments. I remember that when I worked in a bank, the tenge current account was the most profitable product for us. The restriction was introduced to fight corruption in the quasi-public sector, although I never understood how it helped, since interest-free balances are even more corrupt. Meanwhile, the state budget loses a good half of this sum. The reason is that budget-funded organizations are additionally barred from opening deposits. Looked at from a bird's-eye view, it works out roughly like this: the Ministry of Finance borrows money from the market at 15% per annum in order to give it to budget-funded organizations, which then place it with second-tier banks for free until they spend it, so that the banks can then use that money to buy Ministry of Finance bonds at 15%. Businesses and households also forgo huge sums that could have stimulated demand and the economy, but which instead leave the country as dividends of second-tier banks and stimulate other countries' economies.

The cap of no more than 1% on interest paid on foreign-currency deposits. Thanks to this, banks could have earned about KZT 130 billion. Before the Fed raised its rate, this was more of a cost than an income for second-tier banks, but as soon as the Fed rate rose above 1%, an arbitrage automatically emerged, helping the banks make money out of thin air by reinvesting in risk-free securities. All this was introduced to combat dollarization, yet we see that it has led to a distortion of the tenge exchange rate, which hurts the country's industry by eroding its competitiveness and drives us ever deeper into Dutch disease.

In general, one can say that the opportunity to earn large sums without risk discourages banks from lending to the economy, since they can earn the required rate of return without taking any risk. Incidentally, of the KZT 2.5 trillion, banks paid only KZT 312 billion in CIT, or 12%, because of the tax breaks for the financial sector, but I will write about that later. It is rather amusing when banks pay less CIT than the country's SMEs.