The number and importance of large multinational banks (MNBs) have both increased significantly over the past two decades, as well as the size and complexity of their networks of foreign affiliates. MNBs present in several countries and with their complex networks of foreign affiliates, pose a particular challenge for bank supervisors that are divided along national borders. Dexia, for instance, was supervised by the national authorities of Belgium, France, Luxembourg, and the Netherlands when it suffered a catastrophic failure leading to a 6 bn EUR bail-out in 2011.
The financial crisis of 2007-08 demanded the design of a more comprehensive regulatory framework. For example, the Single Supervisory Mechanism (SSM) of the European Banking Union aims to address coordination failures by giving supervision powers for the “most significant entities” (currently 129 banks) to a supranational authority, the ECB. These developments represent a major change in the organization of banking supervision and clearly the banking system itself will not remain indifferent to such a drastic overhaul of the supervisory architecture. In a recent paper we show that the banking system is likely to react to changes in the supervisory architecture, possibly modifying the structure of networks of foreign affiliates in a way that may severely limit the gains from centralizing cross-border bank supervision, unless other actions are implemented.
When a host authority monitors the foreign subsidiary of an MNB (a legally independent entity), it increases the value of the MNB’s foreign assets, which can be used to compensate for potential losses in the home unit, thus alleviating the burden on the home country’s deposit insurance fund. As expected, we show that this positive externality exerted by the host supervisor tends to induce sub-optimally low monitoring by the home supervisor.
Putting a supranational supervisor such as the ECB in charge of all of an MNB’s units solves this “supervisory failing”. The single supervisor will internalize the effect of monitoring the entire MNB, thus monitoring more, inducing a desirable reduction of the interest rates to be served to the bank’s creditors, and alleviating the burden on national deposit insurance funds.
However, this more intense monitoring is also expected to reduce the profitability of a cross-border network of foreign subsidiaries relative to alternative forms of banking organizations. Since an MNB may choose to operate with foreign subsidiaries precisely because it allows it to exploit the coordination problem between national supervisors, when supranational supervision removes this friction, the implicit subsidy to the subsidiary structure disappears. We can expect that MNBs will find it more profitable to turn their foreign units into branches (not legally distinct from the parent holding), or to shut them down altogether. The home country’s deposit insurance fund would thus become responsible for all depositors (home depositors and possibly also foreign ones, according to current rules) and home authorities would be in charge of supervising home and possibly foreign branches. The banking system may thus endogenously react to supranational supervision by reverting to an organizational form in which supranational supervision is actually less needed.
When the MNB changes its organizational form from subsidiary-based to either branch-based or domestic banking, it also shifts the burden of potential losses from the host deposit insurance fund to the home fund. Interestingly, we show in our paper that such a change happens when the home deposit insurance fund is actually weaker than the host fund. When insuring depositors remains a national matter, as in the current European Banking Union, there is thus the risk that supranational supervision affects the organization of cross-border banking in a way that puts a heavy burden on the most strained deposit insurance schemes.
Establishing a common deposit insurance scheme seems like a natural next step. However, we find that the higher credibility of a common deposit insurance scheme further increases the monitoring incentives of the supranational supervisor, thus moving the balance of banks’ profitability towards domestic banking: a paradoxical result for a banking union.
A more natural policy tool would be for the supervisor to put a price on the different legal structures. To the extent that branches and subsidiaries do not give rise to the same level of supervisory monitoring and hence supervision costs and to the same (expected) transfers from the deposit insurance fund, both supervisory fees and deposit insurance premia should in principle depend on the structure of the MNB. Indeed, we show that with “representation-form-dependent” premia, banks can be given incentives to adopt a preferred representation form, aligning profitability with welfare. In practice, this requires detailed information on the complex organizational structure of the MNB, but we think such an effort is necessary to understand and properly price the amount of public money at stake with MNBs.
Giacomo Calzolari is Professor of Economics at the University of Bologna and Research Fellow at the Centre for Economic Policy Research (CEPR) London. Jean-Edouard Colliard is Assistant Professor of Finance at HEC Paris. Gyöngyi Lóránth is Professor of Finance at the Faculty of Business, Economics and Statistics at the University of Vienna and a Research Affiliate at the Centre for Economic Policy Research (CEPR) London.