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27 September 2015

VoxEU: Regulatory arbitrage in action: Evidence from cross-border lending

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Authors show new evidence on avoiding macroprudential policies by borrowing from abroad. Domestic non-banks borrow more from abroad after an increase in capital requirements, but not after an increase in lending standards.

Following the Global Crisis, macroprudential policies have become part of many central banks' toolkits. These instruments are being actively used to address cyclical and structural risks within financial systems – and as such, there has been extensive debate about the use of different instruments for different microprudential and macroprudential objectives.

There is a recent and rapidly expanding literature on the effects of macroprudential instruments). But the effectiveness of these instruments may be compromised if banks and borrowers are able to avoid these measures via regulatory arbitrage or if the regulation is subject to ‘leakages’ whereby the activity migrates to institutions that are not covered by the instruments.

Much of the debate over leakages has focused on lending by ‘shadow banks' or non-bank financial institutions, but another kind of regulatory leakage stems from internationally active banks. Some macroprudential instruments – in the absence of reciprocal arrangements – cannot be applied to all financial institutions within a country. As an example, capital regulation may apply unevenly as foreign branches and cross-border lending are not necessarily subject to the same regulatory measures as domestically-regulated banks. In contrast, product regulation, such as placing a limit on the maximum loan-to-value mortgage a household can get, usually applies to all products sold in a particular country.

Differences in regulation are a significant driver of cross-border banking, as banks expand lending to countries with lower regulatory standards. Aiyar et al. (2012) examine the issue of leakages for time-varying in minimum capital requirements in the UK and find that foreign branches can be a considerable source of ‘leakage’ as they expand their lending into the UK after an increase in UK banks’ capital requirements because they are not subject to the capital requirements. Authors examine whether these leakages apply to a broad range of macroprudential instruments in a cross-country study (Reinhardt and Sowerbutts 2015).

The authors’results suggest that a tightening of capital regulation induces domestic non-banks to increase their borrowing from foreign banks, while a tightening of lending standards does not have the same effect, which suggests that uneven application of bank capital regulation may be a driver of international banking flows. This is over and above the effect, which has been documented extensively in the literature mentioned above, where banks transfer funds to markets with fewer banking regulations. Their results show a subtle contrast – banks transfer funds to countries that tighten regulatory standards, but transfer these funds when the regulatory tightening does not apply to them, and instead confers upon them a competitive advantage.

Authorities are able to apply capital regulation to subsidiaries that they supervise, but not branches. This suggests that leakages should occur via branches. By accounting for measures of the relative of importance of branches versus subsidiaries taken from Fiechter et al. (2011), authors show that the evidence on leakages is indeed stronger for banking systems where foreign affiliates are mainly organised as branches.

Their results also suggest that instrument choice matters for the effectiveness of macroprudential policy. Indeed, some of the results in the literature – which focuses on the domestic effects – may be influenced by how open and subsidiarised the country's banking system is, and the fact that currently reciprocity arrangements only apply to the countercyclical capital buffer. Their research is supportive of building strong reciprocity frameworks with a high degree of automaticity as the leakage occurs soon after the action is taken.

It is a welcome fact that reciprocity of the countercyclical capital buffer is a cornerstone of Basel III, and EU law requires automatic reciprocation of CCB rates from 2016. These rules do not, however, proscribe rules for all potential macroprudential instruments. The results presented in here suggests that there are also likely to be leakages with regard to other capital and liquidity-like policies suggesting that there may be benefits from extending the principle of reciprocity further. At the European level, assessing the cross-border impact of macroprudential policies and coordinating member states' actions is at the heart of the mandate of the European Systemic Risk Board. Capital rules (CRD IV/CRR), which have been in force since 1 January 2014, already foresee some coordination procedures involving the European Systemic Risk Board for specific instruments. But more work needs to be done on working out an optimal and feasible reciprocation and coordination strategy.

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