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Supranational Supervision: what consequences on multinational banks and on governments?

Finance

As the Single Supervisory Mechanism (SSM), the system of supervision for Euro Area banks centered on the European Central Bank (ECB), is now well into its fifth year of operation, the financial press offers constant reminders of the role of regulation and supervision in shaping the decisions of large multinational banks (MNBs). In particular, recent examples have highlighted their impact on banks’ locational choices, be it in the case of banks relocating some of their operations from London to other European cities in the anticipation of Brexit, or in the case of CommerzBank, which may soon become the target of a European cross-border bank merger.

Banque Centrale Frankfort ©gertect-AdobeStock_cover

How does the location of the different units of a multinational bank affect the way it is regulated and supervised? Conversely, how do recent regulatory changes such as supranational supervision by the SSM change MNBs’ organizational structures?

 

How does the location of the different units of a multinational bank affect the way it is regulated and supervised? 

 

The “Branchification" trick: Changing a bank’s nationality by changing its legal status

Moving hundreds of employees from one country to the other is an obvious way for an MNB to change the nationality of a given unit of the MNB. A less visible but perhaps even more consequential way of achieving the same outcome is to change the legal status of this unit. For instance, during the Euro area sovereign debt crisis several foreign banks converted their subsidiaries operating in Portugal into branches. As a result, these banks became supervised by the authorities of the parent bank’s country of incorporation, and covered by the deposit insurance fund of that country.1

Conversely, in 2015, Alpha Bank, headquartered in Greece, operated branches in Bulgaria and Romania, covered by a deteriorating Greek deposit insurance fund. After large deposit withdrawals, these branches were acquired by other Greek banks and reorganized into subsidiaries, thus covered by the local authorities.

More generally, Euro area countries had 550 branches and 310 subsidiaries from other E.U. countries in 2012, against 552 branches and 232 subsidiaries in 2016 (ECB Report on E.U. Structural Financial Indicators, 2016). 

This relative “branchification" process seems at odds with a trend toward using more subsidiaries at the global level.3

Bank run crise Greece
A queue (or "bank run") at National Bank of Greece in Galatsi, Athens

 

This relative “branchification" process seems at odds with a trend toward using more subsidiaries at the global level.


Bank supervision arrangements

One second fact that is often overlooked is the importance of bank supervision arrangements for choosing a bank’s legal structure. 

A recent example is Nordea: originally a Swedish bank, Nordea operated subsidiaries in Denmark, Finland, and Norway. In January 2017, it converted its subsidiaries into branches, thus moving them under the umbrella of Swedish supervisors. In December of the same year, Nordea moved its headquarters to Finland and thus under Finnish supervision. 

As a result of these different moves, the operations of Nordea are now all under the supervision of the SSM.

Why a national authority may not supervise a foreign subsidiary optimally

In our recent research, we propose a theoretical framework to think about this complex interaction between a bank’s legal structure, bank supervision, and the introduction of the SSM.

Our framework identifies two opposite reasons why a national authority may not supervise a foreign subsidiary in an optimal way, making supranational supervision by an authority such as the European Central Bank (ECB) useful:

1. Intervention externality: The national authority does not take into account that being “tough” on this subsidiary reduces the profit of the parent bank, and thus its ability to absorb losses in other jurisdictions. Due to this “intervention externality”, national supervisors can be too harsh on subsidiaries, and a supranational authority is more lenient.

2. Information externality: The national authority does not internalize that collecting information about the soundness of the subsidiary gives relevant information to the supervisor of the parent bank on how to supervise the entire group. Due to this “information externality”, national supervisors can exert too little monitoring compared to a supranational authority.

When the intervention externality dominates, introducing a supranational supervisor such as the ECB makes supervision of subsidiaries more lenient, which at the margin encourages multinational banks to operate with subsidiaries rather than with branches. Moreover, in this case the profitability of the affected MNBs increases. 

When instead the information externality dominates, supranational supervision of subsidiaries is tougher, which at the margin encourages multinational banks to operate with branches rather than with subsidiaries. In this case the profitability of the affected MNBs decreases.

The introduction of supranational supervision may have unintended consequences, such as ultimately increasing the losses to the governments insuring the bank’s depositors, or encouraging banks to shut down their foreign units. 

In both cases, the introduction of supranational supervision may have unintended consequences, such as ultimately increasing the losses to the governments insuring the bank’s depositors, or encouraging banks to shut down their foreign units. 

Consequences of a centralized supervision

Our model is very stylized and focused on the introduction of the SSM, but it makes two points, which are important and go beyond this particular example:

1. In our model, the unintended consequences of centralized supervision arise because society does not adequately price the insurance of deposits. Conversely, such consequences could be avoided if, all else equal, multinational banks had to pay lower deposit insurance premia when using branches rather than subsidiaries. 

The difference would reflect that the branch structure offers co-insurance between the different units of the MNB and reduces the expected losses of the deposit insurance fund. 

While such pricing of deposit insurance does not currently exist, it is a natural tool and maybe the only one that can avoid the unintended consequences studied in our paper, while still allowing MNBs to choose the legal structure that best corresponds to their business needs.

While such pricing of deposit insurance does not currently exist, it is a natural tool and maybe the only one that can avoid the unintended consequences studied in our paper, while still allowing multinational banks to choose the legal structure that best corresponds to their business needs.

2. Many recent regulatory reforms affect subsidiaries and branches differently, such as forcing subsidiaries of foreign banks to operate under the umbrella of a common holding company4, giving more supervisory powers to host countries of foreign branches, or letting national supervisors ring-fence local activities of foreign banks. 

While all these policies may be useful, they all take the structure of the affected MNBs as given. As a consequence, they run the risk that MNBs are going to adjust their structure so as to minimize the impact of these new policies, possibly also generating other unintended consequences.

 


References:

1 See Bonfim, D. and J. Santos (2017): “The importance of deposit insurance credibility”, Working Paper.

2 See novinite.com, “Greek Eurobank takes over Alpha bank's branch network in Bulgaria”, 18 July 2015.

3 See “The globalisation of banking: How is regulation affecting global banks?”, BBVA Research, 2016.

4 The Federal Reserve now requires large foreign banks active in the United States to operate under an “intermediate holding company” supervised by the Federal Reserve. The European Commission proposed a similar rule for non-European banks operating in the E.U.

Article by Jean-Edouard Colliard, based on his research “Multinational Banks and Supranational Supervision” with Giacomo Calzolari and Gyongyi Loranth (Review of Financial Studies, Forthcoming).

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