Foreign Investment, Regulatory Arbitrage, and the Risk of U.S. Banking Organizations

Abstract

This study investigates the implications of cross-country differences in banking regulation and supervision for the international subsidiary locations and risk of U.S. bank holding companies (BHCs). We find that BHCs are more likely to operate subsidiaries in countries with weaker regulation and supervision and that such location decisions are associated with elevated BHC risk and higher contribution to systemic risk. The quality of BHCs’ internal controls and risk management plays an important role in these location choices and risk outcomes. Overall, our study suggests that U.S. banking organizations engage in cross-country regulatory arbitrage, with potentially adverse consequences.

The Role of Regulatory Arbitrage in U.S. Banks' International Flows: Bank‐level Evidence

“…I also find that a broader network of foreign affiliates corresponds to stronger capital rule avoidance in foreign expansion and affiliate lending. Insofar as a bank's broader geographic scope also helps develop sophisticated practices of managing the risk of foreign operations, my findings on the positive relationship between global affiliate scope and regulation avoidance behavior are in line with those of Frame, Mihov, and Salz (2017).…”

“…Presence. An important way in which U.S. banks can engage in regulatory arbitrage is by strategically locating their affiliates in less-regulated jurisdictions (Frame, Mihov, and Salz 2017;Houston, Lin, and Ma 2012). In Table 6, I examine the empirical relationship between host country bank regulatory variables and U.S. banks' Foreign Market Presence choices.…”

“…Ongena, Popov, and Udell (2013) find that stricter bank activity restrictions and higher capital requirements at home lower banks' business lending standards abroad. Frame, Mihov, and Salz (2017) show that U.S. banks locate their subsidiaries in host countries with lax bank regulations, and Karolyi and Taboada (2015) find that banks in strictly regulated countries engage in cross-border mergers with less-regulated targets. Carbo-Valverde, Kane, and Rodriguez-Fernandez's (2012) results also indicate arbitrage in cross-border bank mergers.…”

“…The second strand examines the relationship between bank characteristics and arbitrage behavior. The only other paper on this topic which I am aware of, Frame, Mihov, and Salz (2017) finds that regulatory arbitrage in subsidiary location choices is prevalent only among banks with sophisticated risk management practices. In my work I take a comprehensive look and examine the relationship between a wide range of bank balance sheet traits and (capital) regulatory arbitrage behavior in affiliate location choices as well as lending flows, and add to the literature by showing that lower-capitalized banks with lower foreign ownership shares are the most averse to capital regulations.…”

“…While several papers show that the relationship between host country regulatory stringency, propensity for arbitrage, and bank risk depends on bank corporate structure (Laeven and Levine 2009), funding sources (Karolyi, Sedunov, and Taboada 2016), capitalization (Boyson, Fahlenbrach, and Stulz 2015), and internal controls (Frame, Mihov, and Salz 2017), only a few papers have studied the relationship between a bank's exposure to foreign capital rules and bank profitability. Frame, Mihov, and Salz (2017) find that U.S. banks which engage in regulatory arbitrage in location choices have higher overall return on their assets. I show that (larger) U.S. banks which have lower exposures to foreign capital rules (resulting from more capital regulatory aversion in past foreign location choices) operate with higher foreign returns on their assets.…”