Finance: Research, Policy and Anecdotes

Supranational cooperation and regulatory arbitrage

Fresh of the press, another paper in my long-standing research programme on cross-border supervisory cooperation and jointly with my long-standing co-authors Consuelo Silva-Buston and Wolf Wagner.  Our previous paper showed that cross-border supervisory cooperation can help improve the stability of cross-border banking groups, but this relationship turns insignificant for very large cross-border groups. This new paper provides one possible explanation for that, but also answers to other questions. Specifically, we gauge the effects of supervisory cooperation between the parent bank supervisor and host country supervisor A on the banking group’s behaviour in subsidiary B. Considering the effect of supervisory cooperation on third parties also allows us to mitigate endogeneity concerns arising from addressing the effect of supervisory cooperation in the affected subsidiary.

 

Using data on 364 subsidiaries belonging to 113 banking groups across 116 host countries and 40 home countries from 1995 to 2013, we  find that banking groups increase lending in a foreign subsidiary when the degree to which their other (foreign) subsidiaries are covered by cooperation agreements increases. The increase in lending is funded by debt and does not lead to higher profitability, suggesting higher risk-taking in the subsidiary. We show that the magnitude of the lending effect is higher when supervisory oversight and market discipline in the subsidiary country are weak relative to the other countries a bank group is operating in. We confirm our findings with syndicated loan data: loans are more likely to be given at third party subsidiaries if supervisory cooperation with parent bank and other host country supervisors increases, especially in the case of risky loans and risky borrowers.   Taken together, our results indicate that supervisory cooperation agreements have negative externalities on third countries, as banks shift risks, undermining their overall effectiveness and suggesting a need to “cooperate on cooperation” across all parent and host country supervisors.  And coming back to our previous paper, as regulatory arbitrage is easier done across larger banking groups with more subsidiaries across more host countries, this can explain why (incomplete) supervisory cooperation does not necessarily lead to stability gains.

 

Here is the VoxEU column discussing our paper.