Bank Supervision Going Global? A Cost-Benefit Analysis

1. Bank Supervision Going Global?A Cost-Benefit Analysis Thorsten Beck Radomir Todorov Wolf Wagner

2. Motivation • Bank failure resolution turned out weak point in recent crisis, especially in case of cross-border banks • “Banks are global in life, national in death” • Recent reform discussion, especially on European level • IMF proposal • EU Commission • Issue of national sovereignty vs. European integration

3. This paper • Simple theoretical model to show the distortions that cross-border activities can introduce in supervisory intervention decision • Abstract from: capital and other regulation, as well as from moral hazard and market discipline, focus on supervisory discipline • Highlight costs and benefits of supra-national supervision • Provide empirical evidence from recent crisis consistent with theoretical model

5. Related literature • Capital regulation and cross-border banking (Loranth and Morrison, 2007; Dell’Arriccia and Marquez, 2006; Acharya, 2003) • Importance of ex-ante burden sharing agreements (Freixas, 2003; Goodhart and Schoenmaker, 2009) • Broader discussion on benefits and costs of cross-border banking (Allen et al., 2011) • Calzolari and Loranth (2010): intervention decision as function of branch vs. subsidiary

6. A simple model • Set-up: one bank, three periods (0,1,2); balance sheet normalized to 1 • No discount factor, interest rate zero • Liabilities: deposits d, equity 1-d • Date 0: Bank invests in illiquid assets • Date 2: assets mature, with prob. l payoff is R>1, with prob. 1- lpayoff is zero and external costs c2 • Date 1: supervisor learns prob. l; bank can be liquidated with return 1 and external cost c1

7. External costs of bank failure • Domino problem • Network, interconnectedness • Hostage problem • Depositors panic • Contagion through payment system • Fridge problem • Destruction of lending relationship, soft information

8. Domestic supervisor’s decision • Domestic supervisor: maximizes domestic return (i.e. return to equity and depositors) • Date 1 payoff: 1-c1 • Expected date 2 payoff: lR - (1-l)c2 • Cutoff point: l*= [1-c1+c2]/[ R+c2] • Cutoff decreases in c1 and increases in c2 • Inefficient resolution technique results in higher external costs • External costs increase in size of failing bank and number of failing banks • Assume noisy signal l – as long as symmetric distribution, intervention threshold the same, welfare lower (Type I and Type II errors)

9. Cross-border activities Supervisor only cares about domestic stakeholders • gD Share of domestic deposits • gE Share of domestic equity • gA Share of domestic assets Decision of home country supervisor l(gDd + gE(R–d)) – (1-l) gAc2 = gDd + gE (1–d) – gAc1 l** = [gDd + gE (1–d) + gA (c2-c1)]/[gDd + gE(R–d)+gAc2] If gD = gE = gA then l* = l**

10. Cross-border activities and intervention decision of national supervisor • If c1=0 intervention threshold l** • Decreases in share of foreign deposits • Increases in share of foreign equity • Decreases in share of foreign asset • If c1>0 intervention threshold l** • Decreases in share of foreign deposits • Increases in share of foreign equity, if c1<< c2 • Decreases in share of foreign assets, if c1<< c2

11. Numerical example

12. Efficient regulatory intervention

13. Branch vs. subsidiary structure • Subsidiary – host country supervisor might be too strict (unless c1 is higher than for domestic banks) • Branch – home country supervisor can only intervene into whole bank; too lenient if high foreign share in assets and deposits (exacerbated if recovery rate in foreign assets less than one) • If lD and lF are different, home supervisor lenient towards negative signals from foreign branches or external failure costs imposed on host country in spite of healthy branch

14. Supra-national supervisor • Can increase welfare by maximizing return to all equity and deposit holders • But: External costs higher or lower than in case of domestic supervisors? • Resolution in period 1 more difficult as different legal systems and across banking markets • Might have more options for resolution • Signal about l might be noisier for supra-national supervisor, resulting in more type I and type II errors • Supranational supervisor improves welfare more if: • More distortions through higher cross-border activities • Good monitoring and supervision tools • European failure resolution scheme, i.e. tools to intervene and resolve

15. Empirical part - Methodology • Use CDS spread at time of intervention as indicator of regulatory leniency • Hypothesis 1: The CDS-spread at the time of intervention i) decreases in the share of foreign equity, ii) increases in the share of foreign assets, and iii) increases in the share of foreign deposits • Hypothesis 2: The CDS-spread at the time of intervention decreases in a bank's net foreign balance. Yi = α+β⋅Fi+ θ⋅Zi+ εi

16. Empirical part - data • 54 cross-border banks from Europe and U.S. intervened between 2007 and 2009 • Hand-collected data on foreign activities • Consider CDS spread 3 days prior to intervention • Absolute CDS spread • CDS spread relative to index

17. Main results

18. Results with net foreign balance (1)

19. Results with net foreign balance (2)

20. Conclusions • Cross-border activities might distort supervisory intervention decision, but this depends on • What kind of activity (deposit, equity, asset) • Mix • Supra-national resolution authority can improve, but only if equipped with supervision and adequate resolution tools • Empirical evidence consistent with theoretical predictions