Is cross-border co-operation in bank supervision effective? Thursday, 28 November 2019

After the global financial crisis, countries have significantly increased their efforts to co-operate in the supervision of their banks. Most notably, the Eurozone has now the Single Supervisory Mechanism, which places the supervision of large banks in the hands of the European Central Bank (ECB). This on top of the many existing co-operation agreements and numerous multilateral agreements. But little is known about whether such co-operation ‘works’, as in: does it help improving the stability of the financial system?

Professor Wolf Wagner of Rotterdam School of Management, Erasmus University (RSM) and his team studied if these agreements work, what their effectiveness is, if the effectiveness depends on the environment in which supervisors operate, and if it is dependent on the type of banks?

Does international co-operation lead to financial stability?

A large theoretical literature has argued for the potential benefits of international banking supervision. Co-operation should lead to higher supervisory stringency as supervisors now take the cost of bank-failures in other countries into account. Co-operation also provides supervisors with new information that should result in better decision-making. On the other hand, some arguments suggest that more co-operation does not necessarily result in higher banking stability. For example, the presence of foreign ownership of banks may make domestic regulators excessively strict, in which case co-operation is expected to reduce bank stability. Also, supervisors face many constraints in practice: they have limited legal powers, are subject to regulatory capture, have imperfect information or face political pressure. Many of these constraints are likely to be compounded in an international setting. This means co-operation agreements – even if well intended – may not result in higher stability.

Supervisory co-operation is effective – but not for the very large banks

The research revealed a positive and economically significant effect of supervisory co-operation. An increase in the supervisory co-operation intensity at the bank level improves the bank's stability. Interestingly, the association was found to be concentrated at the smaller cross-border banks. These ‘small’ banks still have an average assets of 22.2 billion USD. This may be explained by the fact that large banks are more complex, and more difficult to supervise. Consistent with this, the research showed that banking supervision is less effective for banks that have a larger number of subsidiaries.

The channel is asset risk

Wagner: “Focusing on the sample of smaller banks, we show that the link between co-operation and bank stability runs through asset risk. This is consistent with the notion that asset risk is difficult to observe and control at arm’s-length; intensive co-operation and information exchange should hence have a pronounced effect. By contrast, bank leverage is not improved through co-operation. This can be explained by leverage already being well-covered by existing (international) regulations, such as capital adequacy standards, and hence being less affected by co-operation.”

The influence of the country’s supervisory and financial system

First, supervisory effectiveness is higher when both home and host supervisor are more stringent. Second, supervisory effectiveness is also higher when the home supervisor has access to higher quality information. Third, co-operation is more effective when there are fewer limits to foreign entry. This likely reflects that there are then a higher number of foreign banks, making supervising foreign entities more important for supervisors.

Co-operation and crises

A potential concern is that co-operation is effective in normal times, but breaks down during crises, and thus when it is most needed. The empirical results, however, show that co-operation remains effective in reducing bank risk, even during the global financial crisis, and – if at all – the influence of co-operation may even get larger. The results also indicate that co-operation is effective in a systemic event as we show that co-operation improves a bank’s Marginal Expected Shortfall (MES).

Lessons for policy

Wagner: “Our analysis offers several important lessons for policy. First and foremost, more co-operation is in principle to be welcomed as it is effective in improving banking stability. However, in order for it to work supervisors need to have the right institutional background, such as sufficient powers and access to quality information. Also, the effectiveness of co-operation declines with bank size, possibly reflecting that supervision of more complex institutions is more difficult. This points to a significant downside of co-operation, as the very large institutions are the ones that pose the highest risk to financial stability.”

This article draws its inspiration from the paper The economics of supranational bank supervision, Centre for Economic Policy Research discussion paper 12764 (updated in 2019).

About the researchers

• Professor Thorsten Beck from Cass Business School, City, University of London
• Dr Consuelo Silva Buston from School of Management, Pontificia Universidad Católica de Chile
• Professor Wolf Wagner from Rotterdam School of Management, Erasmus University (RSM).