Bank Supervision Going Global? A Cost-Benefit Analysis

Thorsten BeckRadomir TodorovWolf WagnerBank Supervision Going Global?A Cost-Benefit Analysis

MotivationBank failure resolution turned out weak point in recent crisis, especially in case of cross-border banksBanks are global in life, national in death Recent reform discussion, especially on European levelIMF proposalEU CommissionIssue of national sovereignty vs. European integrationThis paperSimple theoretical model to show the distortions that cross-border activities can introduce in supervisory intervention decisionAbstract from: capital and other regulation, as well as from moral hazard and market discipline, focus on supervisory disciplineHighlight costs and benefits of supra-national supervisionProvide empirical evidence from recent crisis consistent with theoretical model

Related literatureCapital regulation and cross-border banking (Loranth and Morrison, 2007; DellArriccia 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. subsidiaryA simple modelSet-up: one bank, three periods (0,1,2); balance sheet normalized to 1No discount factor, interest rate zeroLiabilities: deposits d, equity 1-dDate 0: Bank invests in illiquid assetsDate 2: assets mature, with prob. l payoff is R>1, with prob. 1- l payoff is zero and external costs c2Date 1: supervisor learns prob. l; bank can be liquidated with return 1 and external cost c1

External costs of bank failureDomino problemNetwork, interconnectednessHostage problemDepositors panicContagion through payment systemFridge problemDestruction of lending relationship, soft informationDomestic supervisors decisionDomestic supervisor: maximizes domestic return (i.e. return to equity and depositors)Date 1 payoff: 1-c1Expected date 2 payoff: lR - (1-l)c2Cutoff point: l* = [1-c1+c2]/[ R+c2] Cutoff decreases in c1 and increases in c2Inefficient resolution technique results in higher external costsExternal costs increase in size of failing bank and number of failing banksAssume noisy signal l as long as symmetric distribution, intervention threshold the same, welfare lower (Type I and Type II errors) Cross-border activitiesSupervisor only cares about domestic stakeholdersgD Share of domestic depositsgE Share of domestic equitygA Share of domestic assetsDecision of home country supervisorl(gDd + gE(Rd)) (1-l) gAc2 = gDd + gE (1d) gAc1l** = [gDd + gE (1d) + gA (c2-c1)]/[gDd + gE(Rd)+gAc2]

If gD = gE = gA then l* = l** Cross-border activities and intervention decision of national supervisorIf c1=0 intervention threshold l** Decreases in share of foreign depositsIncreases in share of foreign equityDecreases in share of foreign assetIf c1>0 intervention threshold l** Decreases in share of foreign depositsIncreases in share of foreign equity, if c1