In its initial proposal to confer supervision powers to the ECB, the European Commission referred to the necessity of complementing the EU-wide regulatory framework with a supranational supervision mechanism. This was meant to avoid “supervisory failings, [which] have, since the onset of the banking crisis, significantly eroded confidence in the EU banking sector and contributed to an aggravation of tensions in euro area sovereign debt markets” (European Commission 2012). In particular, large multinational banks (MNBs) present in several countries and with a complex network of foreign affiliates pose a particular challenge for bank supervisors divided along national borders. Dexia, for instance, was supervised by the national authorities of Belgium, France, Luxembourg, and the Netherlands, and yet suffered a catastrophic failure leading to a €6 billion bailout in 2011.
A new supervisory architecture in the Eurozone, the Single Supervisory Mechanism (SSM), aims at solving such failures by giving supervisory powers to a supranational authority, namely the ECB. As of 2016, the 129 “most significant entities” are directly supervised by the ECB. The SSM is a major change in the organisation of banking supervision in Europe. It is clear that the banking system itself will not remain indifferent to such a drastic overhaul of the supervisory architecture. This endogenous reaction of supervised banks needs to be taken into account when designing the supervisory framework. Otherwise, banks can react in a way that partially undoes what the supervisory change was trying to achieve.
MNBs’ foreign networks and supervision
The number and importance of MNBs have both increased significantly over the past two decades, as well as the size and complexity of their networks of foreign affiliates (see Claessens et al. 2014). These banks can adopt one of two main forms for their foreign units in order to be active abroad with full operability: subsidiary or branch.
A foreign subsidiary is an independent legal entity, separate from the parent MNB. It is supervised by the host country’s supervisory authority and its depositors are covered by the host deposit insurance fund. Moreover, in case of default, limited liability protects the parent MNB from covering the subsidiary’s losses.
In contrast, a foreign branch is not legally distinct from the MNB. It is thus supervised by the home country’s authority and covered by the home country’s deposit insurance. The MNB has to cover losses in the foreign unit – the branch cannot default without the MNB defaulting.
Whether to operate abroad with a branch or a subsidiary is a strategic decision for a MNB, entailing different costs and benefits in terms of regulation. If the terms of the trade-off change due to a move towards supranational supervision, the MNB can also change the organisation of its foreign network and the representation form of its foreign unit. It may also choose to simply shut down an existing foreign unit, and revert to domestic banking only.
Supranational supervision of an MNB
In a recent paper, we show that the banking system will react to the new supervisory architecture, possibly by changing the structure of foreign networks of affiliates and in a way that may severely limits the gains from centralising bank supervision (Calzolari et al. 2016).
A specificity of the subsidiary structure is that it subjects the MNB to supervision by different authorities, at least one in the home country and one in the host country. Both authorities may have different objectives. In particular, they are often supposed to protect different deposit insurance funds, which are national. When the host authority monitors the foreign subsidiary, this increases the value of the MNB’s foreign assets, which can compensate potential losses in the home country and thus alleviate the burden on the home deposit insurance fund. In other words, the host supervisor exerts a positive externality on the home supervisor when monitoring the foreign unit. Therefore, monitoring can be sub-optimally low under national supervision.
In principle, putting a supranational supervisor such as the ECB in charge of both units solves this problem, as the supervisor will internalise the effect of monitoring the foreign unit on the entire MNB. This is a micro-founded example of a ‘supervisory failing’ that can be solved by supranational supervision.
The shift to supranational supervision is expected to increase monitoring, which in turn decreases the interest rates that have to be served to the subsidiary’s creditors, and alleviates the burden on the deposit insurance funds of both countries. However, if the MNB reacts by changing its representational form, the unambiguously positive impact of supranational supervision is no longer warranted.
The strategic reaction of MNBs to the SSM
Supranational supervision makes little difference to branch MNBs and to purely domestic MNBs. Indeed, in both cases, only one supervisor is in charge, and all potential losses accrue to the national deposit insurance fund, so that there is no coordination problem in the first place. Therefore, the more intense monitoring just described for a subsidiary foreign network will reduce the profitability of that type of network relative to alternative forms of organisation. Since a MNB may choose to operate with a subsidiary precisely because it allows exploiting the coordination problem between national supervisors, when supranational supervision removes this friction, the implicit subsidy to the subsidiary structure disappears, and the MNB can find it more profitable to turn the foreign unit into a branch, or to shut it down. We should thus expect that the banking system will endogenously react to supranational supervision by reverting to an organisational form in which supranational supervision is actually less needed.
However, this is not the unique change we can expect. When the MNB changes its organisational form from subsidiary to either a branch or to domestic banking, it also shifts the burden of potential losses from the host deposit insurance fund to the home fund. Interestingly, we have shown that such a change happens when the home deposit insurance fund is actually weaker than the host fund. There is thus a risk that in the long run, the SSM may affect the organisation of cross-border banking in a way that also puts a heavy burden on the most strained national deposit insurance schemes.
Does the Banking Union need additional supervisory tools?
Currently, a specificity of the current European Banking Union is the lack of overlap between the level at which supervision is organised and the level at which deposit insurance is provided. Establishing a common deposit insurance scheme seems like a natural next step, and this is in fact the third (currently missing) pillar of the Banking Union (the other two being the SSM and a resolution framework with bail-in procedures). Can it also solve the problem we have unveiled above? Actually, we find the opposite – the higher credibility of the common deposit insurance scheme increases the monitoring incentives of the supranational supervisor, thus heightening the discrepancy between the branch and the subsidiary structures.
A more natural solution would be for the supervisor to put a price on the use of 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 theoretically be given incentives to adopt a preferred representation form. In practice, this requires detailed information on the complex organisational structure of the MNB, but such an effort is necessary to understand and properly price the amount of public money at stake with MNBs.
The organisation of supervisory authorities has been at the centre of interesting and intense regulatory debates, both in the EU and in the US. The implemented steps, such as the SSM, will face the industry’s reaction to the modified supervisory approach, and academic research should help understand where these steps are taking multinational banking.
Claessens, S and N Van Horen (2013) “Impact of foreign banks", Journal of Financial Perspectives, 1(1): 29:42-1.
Calzolari, G, J-E Colliard and G Lóránth (2016) “Multinational banks and supranational supervision”, CEPR Discussion Paper No. 11326.
European Commission (2012) “Proposal for a Council Regulation conferring specific tasks on the European Central Bank concerning policies relating to the prudential supervision of credit institutions”, 12 September.