Foreign Investment, Regulatory Arbitrage, and the Risk of US Banking Organizations

60 Pages·2017·0.48 MB·English

FEDERAL RESERVE BANK of ATLANTA WORKING PAPER SERIES

Foreign Investment, Regulatory Arbitrage,
and the Risk of U.S. Banking Organizations

W. Scott Frame, Atanas Mihov, and Leandro Sanz

Working Paper 2017-2
March 2017

Abstract: This study investigates the implications of cross-country differences in banking regulation and
supervision for the international subsidiary locations and risk of U.S. bank holding companies (BHCs).
We find that U.S. BHCs are more likely to operate subsidiaries in countries with weaker regulation and
supervision and that such location decisions are associated with elevated BHC risk and higher
contribution to systemic risk. The quality of BHCs’ internal controls and risk management play an
important role in these location choices and risk outcomes. Overall, our study suggests that U.S. banking
organizations engage in cross-country regulatory arbitrage with potentially adverse consequences.

JEL classification: G15, G21, G28

Key words: regulation, supervision, bank holding companies, cross-border operations, subsidiary
locations, risk, systemic risk

The authors thank David Becher, Thorsten Beck, Allen Berger, Mitchell Berlin (discussant), Mark Carey (discussant),
Eugeneio Cerutti, Stijn Claessens, Ricardo Correa, Ibrahim Ergen, Jean-Pierre Fenech (discussant), Jeffrey Gerlach, Linda
Goldberg, Neeltje van Horen (discussant), Andrew Karolyi, Nada Mora, Ned Prescott, John Sedunov, Marti Subrahmanyam,
Judit Temesvary, Barry Williams, and seminar and conference participants at the Reserve Bank of Australia, the 2016
International Conference on Financial Cycles, Systemic Risk, Interconnectedness, and Policy Options for Resilience, the 2016
Federal Deposit Insurance Corporation/Journal of Financial Services Research 16th Annual Bank Research Conference, the
2016 Conference on Financial Intermediation in Emerging Markets, and the 2017 Allied Social Sciences Association annual
meeting for valuable comments and suggestions. They also thank Tobias Adrian and Markus Brunnermeier for providing
bank holding company risk data, and Andrew Ellul and Vijay Yerramilli for providing bank holding company risk management
quality data. The views expressed here are the authors’ and not necessarily those of the Federal Reserve Bank of Atlanta,
the Federal Reserve Bank of Richmond or the Federal Reserve System. Any remaining errors are the authors’ responsibility.

Please address questions regarding content to W. Scott Frame, Federal Reserve Bank of Atlanta, Research Department, 1000
Peachtree Street NE, Atlanta, GA 30309-4470, 404-498-8783, [email protected]; Atanas Mihov, Federal Reserve Bank of
Richmond, 530 East Trade Street, Charlotte, NC 28202, [email protected]; or Leandro Sanz, Federal Reserve Bank
of Richmond, 530 East Trade Street, Charlotte, NC 28202, [email protected].

Federal Reserve Bank of Atlanta working papers, including revised versions, are available on the Atlanta Fed’s website at
www.frbatlanta.org. Click “Publications” and then “Working Papers.” To receive e-mail notifications about new papers, use
frbatlanta.org/forms/subscribe.
1 Introduction
The international banking system has evolved into an increasingly important cross-border
conduit for the transfer of capital (McGuire and Tarashev (2008)). In fact, according to the
Bank for International Settlements (BIS), foreign claims of international banking organiza-
tions surged 30-fold, from $3.7 to $111.5 trillion dollars, between 1995 and 2013. Foreign
claimsassociatedexclusivelywithU.S.bankingorganizationsroseintandemoverthisperiod
and stood at $12.9 trillion in 2013. Figure 1 illustrates these trends.
[Insert Figure 1 about here]
The rapid growth of international banking can be broadly attributed to technological ad-
vancements, as well as trends towards capital market liberalization and economic integration
(e.g., Focarelli and Pozzolo (2005)). However, the distribution of international banking flows
has been found to vary significantly depending on host country economic and institutional
characteristics,includingthestringencyofbankingregulationandsupervision(Houstonetal.
(2010)). The recent global financial crisis highlighted international financial linkages within
and between global banking organizations, and also exposed limitations associated with ma-
terial cross-border differences in regulatory environments. Since that time, significant policy
attention has been paid to improved international coordination in setting banking regulatory
and supervisory standards through the Financial Stability Board and Basel Committee on
Banking Supervision.1
An important issue for policymakers is regulatory arbitrage: the situation where coun-
tries with weaker regulatory environments attract capital flows from banking organizations
1In the extreme, one might imagine centralizing international banking regulation (rather than seeking to
coordinateonbroadprinciples). Butsuchanapproachcouldbeverycostlyandnecessarilylimittheflexibility
in policy design tailored to the banking sector of individual countries (Morrison and White (2009)).
1
domiciledincountrieswithstricterrules(e.g., Tarullo(2010)).2 Differentperspectivesonthe
implications of this form of regulatory arbitrage have emerged. On one hand, this strategy
may enable banking organizations to effectively evade costly regulation, which ultimately
improves capital allocation efficiency and enhances global economic growth. Alternatively,
regulatory arbitrage may be viewed as a “race to the bottom,” whereby banking organiza-
tions can engage in excessive risk-taking by operating in countries with lax oversight (Barth
et al. (2004)). This second view of regulatory arbitrage suggests that such behavior could
have adverse consequences for bank-specific performance in the form of excessive risk taking
and also contribute to a build-up of system-wide risks.
Understanding whether banking organizations actually engage in regulatory arbitrage
and (if so) the implications for bank-specific and systemic risk is crucial for calibrating the
design of global regulatory and supervisory standards. This paper explores these issues by
studying whether cross-country differences in banking regulatory environments are associ-
ated with the subsidiary location choices and risk profiles of U.S. bank holding companies
(BHCs). We focus on subsidiaries as the mechanism for regulatory arbitrage since these are
separate legal entities incorporated in host countries and subject to those nations’ regula-
tory regimes (Focarelli and Pozzolo (2005), Fiechter et al. (2011), Ongena et al. (2013)). By
contrast, direct exposures or those through foreign branches are subject to home country
regulations.
Using supervisory information about the international structure of U.S. BHCs from 1995
to 2013, we first investigate whether differences in the stringency of regulation and su-
2The International Monetary Fund’s Managing Director at the time, Dominique Strauss-Kahn, stated:
“One of the lessons of the crisis is that we must avoid regulatory arbitrage. Key aspects of prudential
regulations must be applied consistently across countries and across financial activities. This is especially
importanttoday,astheroadtoasaferfutureinvolvesstrengthenedfinancialregulationandsupervision,not
only of cross-border institutions but also of cross-border markets. This will only work if all countries sign
on and take ownership of the initiative, and resist the temptation to offer loopholes” (“Crisis Management
and Policy Coordination: Do We Need a New Global Framework?”, Oesterreichische Nationalbank, Vienna,
May 15, 2009).
2
pervision across countries influences the international subsidiary locations of these institu-
tions. Consistent with regulatory arbitrage, we find that U.S. BHCs are more likely to have
subsidiaries in countries with laxer regulatory environments (defined as fewer activities re-
strictions, less stringent capital requirements, and weaker supervision).3 Moreover, these
relationships are consistent for both traditional commercial banking subsidiaries as well as
non-traditional subsidiaries (e.g., those engaging in securities, insurance, asset management,
or real estate). On average, we estimate that a one standard deviation decrease in the strin-
gency of regulation and supervision corresponds to an increase of 1.3 percentage points in
the probability of having a subsidiary in a given country.4
Previous research has shown that the quality of U.S. BHCs’ risk management function is
crucialforcurtailingtheirriskexposures(EllulandYerramilli(2013)). Hence, weexplorethe
potential link between BHC risk management quality and country regulatory environment
with respect to foreign subsidiary location decisions. We document that banking organi-
zations with stronger risk management functions are more likely to engage in regulatory
arbitrage. This result, which could stem from BHCs’ choices and/or supervisory limitations,
may reduce some concerns about excessive risk-taking.
We then more directly investigate the risk implications of U.S. BHCs’ foreign subsidiary
location decisions. We find that BHCs with subsidiaries in countries with weaker regulatory
regimesareriskierandalsocontributemoretosystemicriskintheUnitedStates. Specifically,
on average, a one standard deviation decrease in the stringency of regulation and supervision
of countries where BHCs have subsidiaries increases VaR and ∆CoVaR by 11.9% and 9.9%
3OurstudyleveragestheglobalbankingregulationdatabasepresentedinBarthetal.(2013),whichbuilds
onfoursurveyssponsoredbytheWorldBank(releasedin2001, 2003, 2007and2011). Thedatasetprovides
information on measures of bank regulation and supervision in 180 countries over the period [1999-2011].
See section 2.2 for more details.
4We also find a relatively weak and fragile empirical relation between regulatory stringency in host
countries and BHC branch locations driven by a single host country — Great Britain. This finding is
consistent with Goldberg and Saunders (1980), who argue that Great Britain played a key role as a driver
of U.S. bank branch expansion abroad, but suggests that U.S. BHCs likely do not engage in regulatory
arbitrage through foreign branch activity. See Section 3.4 for more details.
3
(relative to the mean), respectively. We also find that BHC risk management quality plays
a critical role in both individual and systemic risk outcomes, as the link between weaker for-
eign regulatory environments and increased risk is primarily driven by institutions with weak
risk management. Overall, our evidence suggests that regulatory arbitrage has potentially
adverse consequences — consistent with the “race to the bottom” interpretation. However,
we also find an important role for risk management systems to limit the heightened risks as-
sociated with banking organization subsidiaries operating in more laxly regulated markets.
Our study contributes to several research streams. The first is an emerging literature
examining the relationship between international banking activity and cross-country differ-
encesinbankingregulationandsupervisionthatfocusesontheissueofregulatoryarbitrage.5
Houston et al. (2012) examine the extent to which cross-country differences in regulatory
environments are related to international bank flows and find evidence consistent with reg-
ulatory arbitrage. Ongena et al. (2013) provide evidence that European banking regulation
affects multinational banks’ lending practices insofar as banks with more stringent domes-
tic regulatory regimes lower lending standards and make riskier loans abroad. Karolyi and
Taboada (2015) show that cross-border bank acquisition flows usually involve acquirers from
countries with stronger regulatory regimes than their targets, and find that target and aggre-
gate abnormal returns around deal announcements are positive and larger when acquirers
come from stricter bank regulatory environments.6 Karolyi et al. (2016) find that cross-
border bank flows are associated with lower systemic risk and improved financial stability in
recipient countries, with results particularly strong in countries with weak regulatory quality.
Temesvary (2016) shows that U.S. banks lend less to countries with stricter bank regulations,
and that banks that do so are more profitable in their foreign activities.
5More broadly, our research also contributes to the large literature examining the economic effects of
cross-country differences in banking regulation and economic liberalization in an international context (e.g.,
Beck et al. (2006), Dell’Ariccia and Marquez (2006), Barth et al. (2008), Houston et al. (2010)).
6For other recent studies that link regulatory issues to cross-border merger activity see Hagendorff et al.
(2008) and Carbo-Valdere et al. (2012).
4
Similar to Temesvary (2016) and unlike the rest of the literature in this area, our re-
search analyzes the foreign activities of U.S. BHCs, some of the very institutions that played
a central role in the 2008-2009 global financial crisis. However, unlike that paper, we focus
on foreign subsidiary locations because these entities are principally subject to host country
regulatory regimes, while foreign branches and direct cross-border exposures fall under the
U.S. regulatory system. By examining U.S. BHCs’ foreign subsidiary locations, we provide
new direct evidence on the extent to which banks engage in regulatory arbitrage. We show
that the regulation and supervision stringency of host countries is a relevant factor for the
location of both traditional and non-traditional subsidiaries. In addition, we provide unique
evidence on the interaction between country regulatory environment and BHCs’ risk man-
agement quality with regards to subsidiary location choices. Crucially, we also document a
strong association between BHCs’ subsidiary locations, regulatory stringency, and BHC risk
profiles, highlighting a channel for the transmission of risk to the U.S. financial system.
Our study also contributes to the literature on the determinants of global banking ac-
tivity. Goldberg and Saunders (1980) test various hypotheses on the drivers of U.S. bank
expansion abroad, with particular emphasis on Great Britain. Miller and Parkhe (1998)
examine U.S. banks’ patterns of foreign operations, including their levels of banking services
and choice of organizational forms in host countries. Focarelli and Pozzolo (2001) focus
on cross-border M&As in the banking industry and investigate which factors make it more
likely for a bank to expand its activities abroad. Buch (2003) finds that information cost
and regulation are correlated with the international asset choices of banks in the European
Union. Focarelli and Pozzolo (2005) examine the importance of institutional characteristics
and market profitability for bank location choice. Mian (2006) studies how cultural and
geographical distance limits foreign lending in poor economies. Sengupta (2007) examines
interactions between foreign entry and bank competition, and discusses lending patterns by
foreign banks. Temesvary (2014) uses a structural dynamic estimation model to link foreign
5
banking activities and foreign market characteristics. Complementary to such literature, we
find that cross-country differences in banking regulation and supervision are an important
determinant of the foreign subsidiary location decisions of U.S. BHCs.
Finally, while an abundance of research examines the determinants of bank risk, most
studies largely ignore the effects of internationalization (Beltratti and Stulz (2012)). Amihud
et al. (2002) examine the effects of cross-border bank mergers and report that, on average,
neither the total risk nor the systematic risk of acquiring banks changes significantly. Sim-
ilarly, Buch et al. (2013) investigate the effects of bank internationalization on domestic
market power and risk for German banking institutions, and document a weak link between
internationalization and bank risk. In contrast, Berger et al. (2016) document a positive re-
lation between internationalization and bank risk, and suggest that this results from foreign
market-specific factors. Cetorelli and Goldberg (2011) highlight the importance of multina-
tional banks in cross-border risk transmissions and the propagation of international liquidity
shocks.7 We extend this literature by documenting an important channel of international-
ization, regulatory arbitrage, through which banking organizations may potentially engage
in excessive risk taking. We also study how the quality of institutional risk management
may influence regulatory arbitrage-related risk outcomes.
Our study also has potential policy implications by contributing to the discussion about
international regulatory coordination. We find evidence consistent with the interpretation
thatU.S.BHCsengageinregulatoryarbitrageandthatthishasaneffectonbothinstitution-
specific and systemic risk metrics. This implies that regulatory arbitrage could undermine
attempts to limit banking organization risk-taking in the aftermath of the global financial
crisis. Reducing cross-country regulatory and supervisory differences through improved in-
ternationalcoordinationofbankingregulationandsupervisionseemsanaturalwaytoreduce
7While not explicitly focusing on the risk implications of BHC internationalization, Laeven and Levine
(2009)examinetheimportanceofregulationsandownershipstructuresofprivatebanksforbankrisktaking
in different countries.
6
potential problems.
2 Data
2.1 Foreign subsidiaries of U.S. BHCs
We start our analysis by examining the international organizational structure of U.S. BHCs
during the period [1995-2013]. These institutions can gain foreign exposure through direct
cross-border activities, or via branches or subsidiaries. Foreign exposures emerging from
direct cross-border activities, such as a loan to a firm based in a foreign country, are gov-
erned by the BHCs’ home country regulations. Likewise, banking activity through foreign
branches, which are integrated into the BHC, are bound by home country regulations. By
contrast, foreignsubsidiariesareseparatelegalentitiesthatmustcomplywithregulationsfor
the jurisdiction in which they operate (Focarelli and Pozzolo (2005), Fiechter et al. (2011),
Ongena et al. (2013)). For this reason, we study the location of U.S. BHCs’ foreign sub-
sidiaries in relation to cross-border differences in banking regulation and supervision.8
Data on the location of U.S. BHCs’ foreign subsidiaries are obtained from the Federal
Reserve’s FR Y-10 report.9 Specifically, we start with the stock of foreign subsidiaries as
of 1995 and then record entry and exit decisions thereafter, including the establishment of
De Novo subsidiaries, acquisition of a controlling interest in existing institutions and loss
of those interests through mergers or divestitures. Importantly, the organizational data
comprises only material exposures. For example, the report excludes subsidiaries that are
8We restrict our analysis to foreign subsidiaries associated with the following NAICS industry classifi-
cations: 522 (credit intermediation and related activities), 523 (securities, commodity contracts, and other
financial investments), 524 (insurance carriers and related activities), 525 (funds, trusts, and other financial
vehicles), 531 (real estate), and 551 (management of companies and enterprises).
9The FR Y-10 report collects data on the organizational structure of U.S. BHCs. For
moreinformationsee: http://www.federalreserve.gov/apps/reportforms/reportdetail.aspx?sOoYJ+
5BzDaGhRRQo6EFJQ==.
7
not controlled by a BHC or actively engaged in a business activity.10 We use these data
to construct a panel data set consisting of 135 unique U.S. BHCs operating 8,194 foreign
subsidiaries during the period [1995-2013].
We capture BHCs’ foreign subsidiary location decisions with PresSub and Ln(NSub).
PresSub is an indicator that equals one if a BHC operates at least one subsidiary in a given
country during a year, and zero otherwise.11 Ln(NSub) is the natural log of one plus the
number of foreign subsidiaries a BHC operates in a given country during a year.
2.2 Cross-country banking regulation and supervision
We use the global banking regulation databased presented in Barth et al. (2013) to measure
the stringency of banking regulation and supervision across countries. The data set has been
used by several recent studies to examine cross-country differences in regulatory stringency
in relation to global banking activities (Houston et al. (2012), Karolyi and Taboada (2015),
Karolyi et al. (2016)).
The banking regulation and supervision data builds on four surveys sponsored by the
World Bank and released in 2001 (I), 2003 (II), 2007 (III) and 2011 (IV). Each survey
recorded regulation and supervision stringency across a large number of dimensions. Since
the survey data are not available yearly, we take values from Survey I for the period 1995-
2001, values from Survey II for the period 2002-2005, values from Survey III for the period
2006-2009, and values from Survey IV for the period 2010-2013.
We focus on three dimensions of regulation and supervision: activities restrictions, cap-
10Control is defined according to the Federal Reserve’s Regulation Y. In particular, a BHC controls a
subsidiaryif: 1)itownsatleast25percentofthevotingsecurities;2)itcontrolstheelectionofamajorityof
the directors, trustees, or general partners (or individuals exercising similar functions); or 3) has the power
to exercise directly or indirectly a controlling influence over the management of the offspring.
11In unreported results, we tested alternative definitions of PresSub. First, we defined PresSub as an
indicator that equals one if a BHC operates at least one foreign subsidiary in a given country during a year,
but excluded all subsidiary entries that occurred prior to 1995. Second, we defined PresSub as equal to one
only in the first year a BHC reports having a subsidiary in a country. Our main results are robust to such
alternative definitions.
8
ital regulation and supervisory power. These measures are relatively broad and capture
historically key macro- and micro-prudential areas of regulatory focus and tools for correc-
tive action, and have received emphasis in prior research (Ongena et al. (2013), Karolyi
and Taboada (2015)). The stringency of each dimension is measured by an index. The
activities restriction index ranges from three to twelve and measures the stringency of reg-
ulation regarding BHC involvement in securities, insurance and real estate activities. The
capital regulation index ranges from zero to ten and measures the degree to which super-
visory authorities oversee capital at risk and the initial source of funds used to capitalize a
bank. The supervisory power index ranges from zero to fourteen and measures the extent
to which supervisory authorities can intervene to prevent and correct problems at financial
institutions by, for example, engaging with external auditors and changing the bank’s orga-
nizational structure, respectively. Finally, to construct a unified measure capturing overall
banking regulation and supervision stringency, we extract the first principal component from
activities restrictions, capital regulation and supervisory power. To ease the exposition of
results, we transform all four indices by subtracting each index from its maximum value so
that higher values indicate weaker regulatory stringency.
Table 2 sorts the total number of distinct U.S. BHC subsidiaries into the countries where
they operate (top thirty countries by representation).12 The summary statistics suggest
significant heterogeneity in foreign subsidiary locations. In the top ten countries, we en-
counter global financial centers such as the United Kingdom, and Japan; emerging markets
such as Brazil; and offshore financial centers such as Mauritius. The summary statistics
also show that banking regulation and supervision stringency varies across the different di-
mensions within countries, suggesting that the indices capture sufficiently distinct aspects
of regulatory intensity. For example, the sample averages of the regulatory indices suggest
12Duetodataavailabilityissues, weexcludetheCaymanIslands, oneofthelargestsubsidiarydestination
countries for U.S. BHC, from our sample. To the extent that the Cayman Islands maintains a relatively
weak regulatory environment, such an exclusion should only weaken our results.
9