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

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. payoff is R>1, with prob. 1- payoff is zero and external costs c 2 Date 1: supervisor learns prob.  bank can be liquidated with return 1 and external cost c 1

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 c 1 ) – 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-c 1 Expected date 2 payoff: R - (1- )c 2 Cutoff point:    = [1-c 1 +c 2 ]/[ R+c 2 ] Cutoff decreases in c 1 and increases in c 2 – Inefficient resolution technique results in higher external costs – External costs increase in size of failing bank and number of failing banks Assume noisy signal  – as long as symmetric distribution, intervention threshold the same, welfare lower (Type I and Type II errors)

Cross-border activities  D Share of domestic deposits  E Share of domestic equity  A Share of domestic assets Decision of home country supervisor  D d +  E (R–d)) – (1-  A c 2 =  D d +  E (1–d) –  A c 1   D d +  E (1–d) +  A (c 2 -c 1 )]/[  D d +  E (R–d)+  A c 2 ] If  D =  E =  A then   

Cross-border activities and intervention decision of national supervisor If c 1 =0 intervention threshold  – Decreases in share of foreign deposits – Increases in share of foreign equity – Decreases in share of foreign asset If c 1 >0 intervention threshold  – Decreases in share of foreign deposits – Increases in share of foreign equity, if c 1 << c 2 – Decreases in share of foreign assets, if c 1 << c 2

Branch vs. subsidiary structure Subsidiary – host country supervisor might be too strict (unless c 1 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 D and F 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 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