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Staff Reports

Regulatory Arbitrage Within the Firm

Number 1196
May 2026

JEL classification: G21, G23, G28, G38

Authors: Nicola Cetorelli and Shohini Kundu

Regulation shapes the boundaries of firms. When prudential standards bind asymmetrically across subsidiaries of an integrated organization, internal capital markets become a mechanism for regulatory arbitrage. We study this in U.S. banking, where holding companies encompass both heavily regulated depository institutions and lightly regulated nonbank affiliates. Following Basel III in 2015, holding companies extract equity from nonbank subsidiaries to recapitalize their banks. Bank subsidiaries accumulate 5-8 percentage points more excess capital than comparable standalone banks through internal transfers; consolidated equity, assets, and lending are unchanged. In response to the same regulatory shock, nonbank affiliates within these organizations exhibit declining capital ratios, deteriorating credit quality, and expansion into consumer lending. The consolidated organization remains exposed to nonbank distress. We calibrate stress scenarios to 2008-scale losses on nonbank assets. If parents were to recapitalize distressed subsidiaries, 4-6 percent of holding companies would exhaust their capital buffers. For the most exposed institutions, the apparent improvement in bank safety is substantially overstated once the implicit liability to nonbank affiliates is accounted for. Organizational structure is a fundamental determinant of regulatory outcomes.

Full Article

Author Disclosure Statement(s)

Nicola Cetorelli
The author declares that he has no relevant or material financial interests that relate to the research described in this paper. Prior to circulation, this paper was reviewed in accordance with the Federal Reserve Bank of New York review policy, available at https://www.newyorkfed.org/research/staff_reports/index.html.

Shohini Kundu
I have no relevant or material financial interests that relate to the research described in the paper, Regulatory Arbitrage within the Firm. Prior to circulation, this paper was reviewed in accordance with the Federal Reserve Bank of New York review policy, available at https://www.newyorkfed.org/research/staff_reports/index.html.

Suggested Citation:
Cetorelli, Nicola, and Shohini Kundu. 2026. “Regulatory Arbitrage Within the Firm.” Federal Reserve Bank of New York Staff Reports, no. 1196, May. https://doi.org/10.59576/sr.1196

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