NATIONAL VERSUS SUPRANATIONAL BANK REGULATION: GAINS AND LOSSES OF JOINING A BANKING UNION Maria Näther and Uwe Vollmer Leipzig University September 23, 2016 MARIA NÄTHER AND UWE VOLLMER SEPTEMBER 23, 2016 1 / 23
MOTIVATION (1/4) MOTIVATION Multinational banks justify supranational bank regulation Multinational banking endangers risks to financial stability at home and in host countries Cross-country spillovers are ignored by a national regulator, but internalized by a supranational regulator Supranational regulation is beneficial for all countries, but not always welcomed by every single country European Banking Union (EBU) allows non-emu-member States to opt-in CEECs currently take a wait-and-see position MARIA NÄTHER AND UWE VOLLMER SEPTEMBER 23, 2016 2 / 23
MOTIVATION (2/4) RESEARCH QUESTION AND MAIN MODEL CHARACTERISTICS How does the structure of international banking affect the decision of a national regulator to join a banking union? We consider a continuum of multinational banks with parent bank in home country and subsidiary in host country Subsidiary s profit contributes to home country welfare, losses to depositors are covered by deposit insurance in host country Failure of parent bank endangers bank stability in host country Regulators can limit bank leverage by imposing capital requirements MARIA NÄTHER AND UWE VOLLMER SEPTEMBER 23, 2016 3 / 23
MOTIVATION (3/4) MAIN RESULTS Multinational regulator takes into account all payments and thus reduces capital requirements in countries hosting many subsidiaries (host country regulator ignores subsidiary s profit first effect) tightens regulation in countries with many parent banks (home country regulator ignores stability costs second effect) A country hosting many subsidiaries prefers supranational regulation if benefit from second effect loss implied by the first effect MARIA NÄTHER AND UWE VOLLMER SEPTEMBER 23, 2016 4 / 23
MOTIVATION (4/4) RELATED LITERATURE Archaya [2003], Holthausen and Ronde [2004], Dell Ariccia et al. [2006]: supranational capital requirements prevent a race to the bottom Beck et al. [2013]: national regulators decisions to bail-out a bank are distorted when banks are internationally active Colliard [2015] and Carletti et al. [2016] : incentives of a national regulator to collect and surpass information to a supranational regulator Goodhart and Schoenmaker [2009], Bolton and Oehmke [2015], Feia and Weder di Mauro [2016]: incentives to accept a cooperative solution in bank resolution MARIA NÄTHER AND UWE VOLLMER SEPTEMBER 23, 2016 5 / 23
TABLE OF CONTENTS TABLE OF CONTENTS 1 MOTIVATION 2 CLOSED ECONOMY CASE 3 OPEN ECONOMY CASE Set-up and bank behavior Welfare Incentives to join 4 APPLICATION TO EBU 5 CONCLUSION MARIA NÄTHER AND UWE VOLLMER SEPTEMBER 23, 2016 6 / 23
CLOSED ECONOMY CASE (1/3) MODEL SETUP (Risk-neutral) agents: Profit-maximizing bank: is endowed with equity E = 1 raises (fully insured) deposits D and invests funds E plus D (leveraging) into a risky project Welfare-maximizing regulator: sets capital requirement κ = 1 1+D or maximum leverage D = 1 κ κ (per unit of equity) Two-period project: { R, with probability p Return per unit invested 0, with probability 1 p p identical with monitoring effort; determined by the bank p is the bank s private information c Cost of monitoring effort: 2 p2 (1 + D) MARIA NÄTHER AND UWE VOLLMER SEPTEMBER 23, 2016 7 / 23
CLOSED ECONOMY CASE (2/3) BANK BEHAVIOR Bank s expected profit at T = 0: Π (p, D) = p [R (D + 1) D 1] + (1 p) ( 1) c 2 p2 (1 + D) = p (R 1) D + pr 1 c }{{}}{{} 2 p2 (1 + D). }{{} profit from deposits profit from equity monitoring costs Profit-maximizing monitoring effort: ( ) p ( D ) = R c D c (1 + D) Bank raises as many deposits as possible MARIA NÄTHER AND UWE VOLLMER SEPTEMBER 23, 2016 8 / 23
CLOSED ECONOMY CASE (3/3) REGULATOR BEHAVIOR Expected payments to all agents (welfare): W (p, D) = p (R 1) (1 + D) + (1 p) ( 1 D) c 2 p2 (1 + D) = (pr 1) (1 + D) c 2 p2 (1 + D). Welfare-maximizing monitoring effort: Regulator s problem: p W = R c R c D c (1 + D) = p (D) D = arg max D κ = Resulting capital requirement: κ = 2c + 1 R 2 or D = 1 1 + D 1 2c + 1 R 2 1 MARIA NÄTHER AND UWE VOLLMER SEPTEMBER 23, 2016 9 / 23
OPEN ECONOMY CASE TABLE OF CONTENTS 1 MOTIVATION 2 CLOSED ECONOMY CASE 3 OPEN ECONOMY CASE Set-up and bank behavior Welfare Incentives to join 4 APPLICATION TO EBU 5 CONCLUSION MARIA NÄTHER AND UWE VOLLMER SEPTEMBER 23, 2016 10 / 23
OPEN ECONOMY CASE SET-UP AND BANK BEHAVIOR COST STRUCTURES home country lending foreign country lending regulator: home country host country monitoring costs: c 2 p 2 (1 + D i ) c 2 p 2 ( 1 + D j ) fee: none f return: R i or 0 R j or 0 costs for the home country regulator: costs for the foreign country regulator: D i (1 p) D j (1 p) + C (1 p) f... fee C... stability costs MARIA NÄTHER AND UWE VOLLMER SEPTEMBER 23, 2016 11 / 23
OPEN ECONOMY CASE SET-UP AND BANK BEHAVIOR SINGLE BANK BEHAVIOR Optimal monitoring effort of home-country projects: p own i (D i ) = R i c D i c (1 + D i ) Optimal monitoring effort of multinational projects: p mult i ( ) R j Dj = c D j c ( ) 1 + D j MARIA NÄTHER AND UWE VOLLMER SEPTEMBER 23, 2016 12 / 23
OPEN ECONOMY CASE SET-UP AND BANK BEHAVIOR BANKING SECTOR STRUCTURE banks in country i nationally active internationally active (1 β i )K own i home country projects multinational projects Ki own β i K own i K mult i... mass of home-country projects realized by banks in country i Ki mult... mass of foreign projects realized by a subsidiary in country j for a parent bank in country i with K i = Ki own + Ki mult β i Ki own... mass of home country projects realized by internationally active parent banks MARIA NÄTHER AND UWE VOLLMER SEPTEMBER 23, 2016 13 / 23
OPEN ECONOMY CASE WELFARE WELFARE IN COUNTRY i (i) { ( ) [ }}{ W i Di, D j = Ki own R i 1) (1 + D i ) c ] 2 (pown i ) 2 (1 + D i ) (p own i (ii) { [ }}{ + Ki mult pi mult ( Rj 1 ) D j + pi mult R j 1 c ( ) 2 (1 pi mult ) ] + Dj F 2 i Kj mult ( ) 1 p mult j Di β j K own ( ) j 1 p own j C, }{{}}{{} (iii) F i... aggregate fees for country i (i) Welfare from home-country projects (ii) Expected return to country i banks from foreign-country projects ( regulatory external effect) (iii) Losses to country i depositors from foreign country projects (iv) Expected stability costs ( regulatory external effect) National regulator s problem: D i = arg max Di W i ( Di, D j ) MARIA NÄTHER AND UWE VOLLMER SEPTEMBER 23, 2016 14 / 23 (iv)
OPEN ECONOMY CASE WELFARE JOINT WELFARE W i+j ( Di, D j ) = Wi ( Di, D j ) + Wj ( Di, D j ) supranational regulator s problem: ( ) ˆD i, ˆD j = arg max W ( ) i+j Di, D j (D i,d j) MARIA NÄTHER AND UWE VOLLMER SEPTEMBER 23, 2016 15 / 23
OPEN ECONOMY CASE WELFARE COMPARISON BETWEEN REGULATORY REGIMES W i C < C krit D j PROPOSITION There is a threshold C krit such that ˆD i > D i if and only if C < C krit. D j ˆD j W i C > C krit monotonicity of ˆD i Di C decreasing constant Ki own decreasing increasing Kj mult increasing decreasing β i decreasing constant D j ˆD j D j MARIA NÄTHER AND UWE VOLLMER SEPTEMBER 23, 2016 16 / 23
OPEN ECONOMY CASE INCENTIVES TO JOIN INCENTIVES TO JOIN Country i joins the banking union if W i ( ˆD i, ˆD j ) Wi (D i, D j ) PROPOSITION The incentive of country i to join the banking union decreases if (A) K mult i decreases and C C ; (B) K own j decreases and C C ; (C) β j increases, while C < C ; or if β j decreases, while C > C ; C, C and C are threshold values. MARIA NÄTHER AND UWE VOLLMER SEPTEMBER 23, 2016 17 / 23
APPLICATION TO EBU TABLE OF CONTENTS 1 MOTIVATION 2 CLOSED ECONOMY CASE 3 OPEN ECONOMY CASE Set-up and bank behavior Welfare Incentives to join 4 APPLICATION TO EBU 5 CONCLUSION MARIA NÄTHER AND UWE VOLLMER SEPTEMBER 23, 2016 18 / 23
Austria Belgium Bulgaria Croatia Cyprus Czech Republic Denmark Estonia Finland France Germany Greece Hungary Ireland Italy Latvia Lithuania Luxembourg Malta Netherlands Poland Portugal Romania Slovakia Slovenia Spain Sweden APPLICATION TO EBU APPLICATION TO EBU (1/3) Foreign bank penetration: 100% 75% 50% 25% 0% share (total assets) of foreign credit institutions 2014 (percent) share (total assets) of domestic credit institutions 2014 (percent) Source: ECB consolidated banking Data MARIA NÄTHER AND UWE VOLLMER SEPTEMBER 23, 2016 19 / 23
Austria Belgium Bulgaria Cyprus Czech Republic Denmark Finland France Germany Greece Hungary Ireland Italy Lithuania Luxembourg Netherlands Poland Portugal Romania Slovakia Slovenia Spain Sweden United Kingdom APPLICATION TO EBU APPLICATION TO EBU (2/3) Structure of foreign banking: 100% 75% 50% 25% 0% subsidiaries branches Source: ECB structural indicators MARIA NÄTHER AND UWE VOLLMER SEPTEMBER 23, 2016 20 / 23
APPLICATION TO EBU APPLICATION TO EBU (3/3) Banking sectors in CEEC are dominated by foreign subsidiaries: Large Kj=EBU mult implies large expected profits accruing to parent banks; Small β j=ebu Kj=EBU own implies small stability costs caused by parent banks Supranational regulator would set smaller capital requirements than national regulator in country i = CEEC Denmark and Sweden show large shares of outward banking claims towards EBU countries Large β i=dk ;SE Kj=EBU own makes EBU membership rather unattractive MARIA NÄTHER AND UWE VOLLMER SEPTEMBER 23, 2016 21 / 23
CONCLUSION TABLE OF CONTENTS 1 MOTIVATION 2 CLOSED ECONOMY CASE 3 OPEN ECONOMY CASE Set-up and bank behavior Welfare Incentives to join 4 APPLICATION TO EBU 5 CONCLUSION MARIA NÄTHER AND UWE VOLLMER SEPTEMBER 23, 2016 22 / 23
CONCLUSION CONCLUSION Differences between national and supranational regulation occur, because national regulators ignore Foreign depositors losses (as a home country for domestic parent banks) and subsidiarys profits (as a host country of foreign subsidiaries) Total expected stability costs occurring to the foreign country because of multinational bank activity Therefore: A country hosting many subsidiaries joins a banking union if financial stability in the host country is relatively dependent from parent banks performance A country with many parent banks owning subsidiaries joins a banking union if financial stability in the host country is relatively independent from parent banks performance MARIA NÄTHER AND UWE VOLLMER SEPTEMBER 23, 2016 23 / 23
Appendix
TIMING T = 0 T = 1 the regulator chooses and announces κ banks simultaneously choose p and D and invest the project s return realizes (R or 0) banks repay equity deposits are repaid either by the bank or by the deposit insurance
GRAPHICAL INTERPRETATION case (A): W i K mult i old new D j ˆD j D j