Supervisory cooperation and regulatory arbitrage

Abstract

While bank supervisors frequently cooperate across countries, novel data on 268 cooperation agreements reveal that such cooperation falls short of covering the global operations of large banking groups. We show that this causes material regulatory arbitrage: banking groups allocate lending activities and risk into third-country subsidiaries when cooperation agreements cover their operations in other countries. The average distortion in a country’s foreign lending caused by regulatory arbitrage is 21 percent, with the effect being magnified in the presence of a weak supervisory framework. Taken together, our results indicate that incompleteness in cooperation substantially diminishes its global effectiveness.