Finance: Research, Policy and Anecdotes

Economics of supranatl. supervision-forthcoming in JFQA

In 2010, in the wake of the Global Financial Crisis that saw the failure and bungled resolution of quite some cross-border banks, my then colleague Wolf Wagner and I started a research programme on cross-border supervisory cooperation. Together with Consuelo Silva-Buston, we have now published the third paper in this line of research.  Our first paper showed theoretically that resolution decisions concerning cross-border banks by national supervisors are biased and provided empirical evidence from the Global Financial Crisis. The second paper showed theoretically that the trade-off between cross-border externalities of bank failures, on the one hand, and differences between countries’ preferences, on the other hand, should determine whether countries are better off moving towards supranational supervision or staying with national supervision.

 

The third paper provides empirical evidence for this theoretical and other models and has just been accepted for publication in the Journal of Financial and Quantitative Analysis.  A first major contribution of the paper is that we have put together a cross-country database on cooperation between countries in Europe, the Americas and Africa (no data for Asia, unfortunately) for the period 1995 to 2013, as well as on different forms of cooperation (including Memorandum of Understanding, Colleges of Supervisory, broader cooperation including on resolution and supranational supervisor). We use this database to ask two questions in this paper: first, is cross-border supervisory cooperation associated with higher bank stability; second: what determines the incidence and intensity of cross-border supervisory cooperation?  On the first, question, we exploit variation within large cross-border banks in terms of cooperation between the parent bank supervisors and different host country supervisors over time. We find that as the parent bank supervisor cooperates with more host country supervisors, a bank’s stability, as measured both by accounting-based (z-score) and market-based measures (Marginal Expected Shortfall). Interestingly, this holds for ‘smaller’ cross-border banks (which includes, for example, Nordea, so still very large banks) rather than for the largest cross-border banks (the moral hazard risk of too-big-to-fail might simply be too large for these) and works through asset risk rather than capital levels. We also find that effectiveness of cooperation increases both with the stringency of home and host supervision, as well as the quality of information that is available to supervisors.

 

In the second part of the paper, we explore why we observe such a large variation across countries in terms of supervisory cooperation, which seems to contradict our findings discussed so far.  The absence of cooperation can be explained by the presence of (economic) costs to cooperation, arising in the form of heterogeneity between countries, such as different preferences, or differences in economic and institutional structures. Benefits from cooperation, on the other hand, stem from the externalities arising from decisions of national supervisors for other banking systems; e.g., individual countries may choose supervision levels that are insufficient from a global perspective as they will tend to ignore that the failure of their banks has international spillovers. We find that the cooperation pattern observed in the data vary consistently with (net) cooperation gains arising from externalities and heterogeneities. Specifically, the existence and intensity of cooperation between two countries, as well as the propensity of a given country-pair to move to cooperation increases in externalities and decreases in bilateral heterogeneities.

 

What can we learn from our results?  First, cooperation improves banking stability but the impact depends critically on institutional characteristics, such as supervisory powers and access to information. Second, the effectiveness of cooperation declines with bank size. Third, a uniform global push towards more coordination of banking supervision may

not necessarily be optimal as the (net) gains from cooperation differ across countries, and actual agreements may already reflect this.

 

Much more research to be done?  So, far, we have taken bank’s cross-border exposures as given, but banks certainly react to supervisory actions, including cross-border cooperation agreements.  Stay tuned….

 

On a final note, as part of my new job at the Florence School of Banking and Finance, we will be organising an on-line Academy on Cross-border Supervisory Cooperation in November/December, combining technical aspects with comparisons of different models of cooperation and policy discussions.  Details to come in the next weeks and months on fbf.eui.eu.