Preliminary!
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
• Highlight costs and benefits of supra-national
supervision
• Abstract from: capital and other regulation, as
well as from moral hazard and market
discipline, focus on supervisory discipline
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)
• 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
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
• How to overcome them (minimize c1)
– Efficient and swift resolution regime, using merger and
acquisition, purchase and assumption, good bank-bad
bank etc.
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)
Cross-border activities
• 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
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
Explaining actual events
• Icelandic banks, high foreign assets and deposits,
domestic equity
– Intervention too late
– Other reasons: regulatory/political capture, lack of
resources…
– Exacerbated through branch structure-host country
supervisors had limited information and intervention
powers
• Fortis: mixed deposits, assets and equity
– Belgian supervisor intervened relatively late
– Dutch supervisor relatively strict (foreign equity)
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
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