Regulatory Arbitrage and the Efficiency of Banking Regulation

It is common to consider that international financial integration weakens the efficiency of banking regulation as national regulatory authorities are involved in a “race to the bottom”, which leads to a relaxation of their requirements compared to those which would be set if there was no integration. Our paper “Regulatory Arbitrage and the Efficiency of Banking Regulation” goes beyond this view: we claim that what is involved is not so much a weakening of regulatory standards as the inability to efficiently regulate risk-taking by banks when they are able to freely direct their investment flows worldwide.

Banking has been an international activity since the medieval ages, when bankers relied on international family networks to move funds across borders. But the international character of banking has been significantly increased due to technological advances and the international opening of capital markets. Since much of bank regulation is based on prudential concerns, the expansion of banks across borders raises the question of the likely impact of financial market integration on the regulatory settings within which banks operate.

Financial integration creates de facto competition between national regulatory jurisdictions. In this environment, a usual concern of policy-makers when imposing tougher regulatory standards than other countries is the revenue loss that can result from the relocation of banks’ financial activities out of their jurisdiction: the banks are able to relocate their activities to jurisdictions with the most favorable regulations to them and regulatory arbitrage has to be taken into account when implementing (new) regulations.

In our paper we tackle the issue of the impact of international mobility of banks and capital flows on the regulatory framework within which banks operate. We set up a model of a multi-country economy with banks. We define international mobility of banks as the capacity of banks to freely choose the regulatory contract under which they operate irrespective of their depositors’ place of residence. This is apparently extreme, but is actually equivalent to the assumption that banks in a given country are free to set up subsidiaries in any country, taking advantage of the international mobility of financial flows. Mobility means that banks can choose the regulatory contract under which they function, i.e. there is a possibility of regulatory arbitrage. Such a possibility creates a market for regulatory contracts, where regulators compete to attract banks. A bank is allowed to function when authorization is granted by some public authority acting as its principal. We resort to agency theory to predict how the regulatory contract under which a bank (or its subsidiary) operates is designed. There is asymmetric information in our model, which means that public authorities have an informational disadvantage in evaluating banks' ability to manage their portfolios. In each country a public authority, the regulator, sets up a contract with the aim of optimally regulating banks according to their ability to manage their portfolios.

Our main results indicate that the competition induced by regulatory arbitrage in a financially open economy invalidates the use of some instruments and consequently critically hampers the regulatory capacity of these authorities. In particular, we show that the internationalization of banks reduces the capacity of national public authorities in charge of banks to discriminate between banks with different abilities to manage their portfolios.

Intuitively the incentive for each regulator to undercut the terms of the regulatory contracts set by its competitors leads to the intuition that there is going to be a “race to the bottom” in terms of regulatory standards. Actually the outcome of our model is more interesting: the endogenous restriction caused by regulatory arbitrage on the capacity of regulators to use several regulatory instruments leads the market for regulatory contracts to a pooling equilibrium so that a unique regulatory contract is offered for banks of different ability to manage their portfolio. This is due to the fact that competition pushes regulators to harmonize practices rendering a separating equilibrium in regulatory markets impossible.

Pierre Boyer is a Professor at the École Polytechnique and Hubert Kempf is a Professor at Ecole Normale Supérieure de Cachan and Paris School of Economics.