Bank Supervision Going Global?
A Cost-Benefit Analysis
Thorsten Beck
Radomir Todorov
Wolf Wagner
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
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
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
A simple model
 Set-up: one bank, three periods (0,1,2); balance sheet
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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- l payoff is zero and external costs c2
Date 1: supervisor learns prob. l; bank can be liquidated
with return 1 and external cost c1
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
Domestic supervisor’s decision
 Domestic supervisor: maximizes domestic return (i.e. return to
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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)
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**
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
Numerical example
Efficient regulatory intervention
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
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
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
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
Main results
Results with net foreign balance (1)
Results with net foreign balance (2)
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