How important is territorial bias in prudential supervision and regulation?

Author:Katia D'Hulster
Position:The World Bank, Washington, District of Columbia, USA
Pages:322-337
SUMMARY

Purpose - The purpose of this paper is to measure and rank territorial bias in prudential supervision and regulation in 22 EU and non-EU countries with financial systems predominantly owned by foreign banks. Design/methodology/approach - Twenty-two host countries are surveyed along six dimensions. First a scoring system is developed to ... (see full summary)

 
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How important is territorial bias
in prudential supervision and
regulation?
Katia D’Hulster
The World Bank, Washington, District of Columbia, USA
Abstract
Purpose – The purpose of this paper is to measure and rank territorial bias in prudential supervision
and regulation in 22 EU and non-EU countries with nancial systems predominantly owned by foreign
banks.
Design/methodology/approach – Twenty-two host countries are surveyed along six dimensions.
First, a scoring system is developed to measure territorial bias on an individual country basis (vertical
analysis). Second, the results are compared across two peer groups, EU and non-EU (horizontal
analysis).
Findings – Territorial bias is present to a varying degree in the prudential supervision and the
regulations of the countries surveyed. On average higher territorial bias is observed in the non-EU
group. Generally, there is also less dispersion in the EU which can be explained by a common regulatory
framework and the efforts to achieve supervisory convergence. Non-EU countries use a wider array of
instruments, typically higher capital ratios, stricter local governance requirements and liquidity
restrictions.
Originality/value – This is the rst quantitative measure and analysis of territorial bias in prudential
supervision and regulation that has been established. It includes condential supervisory measures and
measures imposed by moral suasion.
Keywords Banking supervision, Banking regulation, Cross border bank, Foreign bank,
Host supervisor, Ring-fencing
Paper type Research paper
1. Introduction
As internationally active banks have expanded their global footprint, the banking
systems of many jurisdictions have become predominantly owned by foreign banking
groups. Before the global nancial crisis, there was near consensus that a strong
presence of foreign banks enhances the safety and soundness of a host country’s
banking system by bringing diversication and nancial strength (Cull and
Martinez-Peria, 2011).
The nancial crisis brought a more nuanced view on the benets of foreign banks
(Claessens and Van Horen, 2012). One of the main reasons is that it started in the typical
home countries and spread to typical host countries. Moreover, the speed of
transmission was unprecedented; many global banking groups entered the crisis with
seemingly very strong capital ratios, but their condition deteriorated very rapidly. To be
fair, most of the concerns associated with foreign banks reect the gaps and weaknesses
of pre-crisis nancial regulation and institutional arrangements. Minimum capital
levels were too low, the quality of regulatory capital was too weak, the risk weights
assigned did not reect actual risk, the potential for liquidity strains was seriously
The current issue and full text archive of this journal is available on Emerald Insight at:
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JFRC
23,4
322
Journalof Financial Regulation
andCompliance
Vol.23 No. 4, 2015
pp.322-337
©Emerald Group Publishing Limited
1358-1988
DOI 10.1108/JFRC-03-2014-0018
underestimated, and the macro prudential component of nancial sector supervision
was virtually absent. Nevertheless, some observations are more closely tied to the
international character of global banks and the weaknesses in cooperation among
supervisors. The most important observation was that resolution powers and regimes
were nationally based, thus complicating the resolution of failing nancial institutions
active in multiple jurisdictions. When a cross-border bank had to be resolved, national
interests took priority and supervisory cooperation broke down (Basel Committee on
Banking Supervision, 2010). The location of capital and liquidity was then critical in the
resolution.
Global policy makers such as the Financial Stability Board (FSB) are addressing
these shortcomings (Financial Stability Board, 2011). Crisis management groups for
globally active banks have also been established, resulting in good progress in the
development of recovery and resolution plans (Financial Stability Board, 2013).
Although signicant steps have been taken at the international and European level in
addressing these misalignments, the resulting policy recommendations are
considerable and come with long implementation and transition periods.
In the meantime and as a second line of defense, some supervisors have decided to
better insulate their national banking systems from cross-border contagion and to
enhance resolvability within their borders. For example, dividend restrictions, higher
liquidity buffers and capital ratios imposed by supervisors to build a more resilient and
self-sufcient domestic banking system have been observed. These unilateral
“ring-fencing” actions or “territorial” approaches by supervisors are aimed to protect the
domestic assets of a bank, so they can be seized and liquidated under local law in case of
failure of the whole, or other entities of, the banking group. D’Hulster and Otker-Robe
(2014) refer to the degree of this separation of the local operations as “territorial bias” or
“home bias[1]”.
Territorial approaches are typically applied by host supervisors. Although, home
supervisors can also introduce territorial bias in their prudential regulation and
supervision. For example, the Austrian Financial Market Authority and the Austrian
National Bank recently introduced a measure to make business models used by
Austrian banks more sustainable. Foreign subsidiaries that are particularly exposed
must ensure that the ratio of new loans to local renancing does not exceed 110 per cent
(Austrian National Bank, 2012).
The incidence of territorial approaches is not well described in the literature and no
quantication can be found. Measuring territorial bias is very difcult, mainly because
of a lack of transparency, as most decisions imposing liquidity or other restrictions on
individual foreign banks remain condential. While banking laws and regulations,
which can also introduce territorial bias, are publicly available, comparing these laws
and prudential regulations, thresholds and calculations across jurisdictions is a
complicated exercise. Moreover, the existence of a supervisory power in the banking law
or the prudential regulation does not automatically mean that it will also be used in
practice.
This paper attempts to ll this gap. A survey of 22 prudential host supervisors of
OECD, EURO or Eastern Europe and Central Asia (ECA) banking systems with foreign
majority ownership forms the basis for a vertical and horizontal analysis. First, a
scoring system that calculates a quantitative measure of territorial bias for each
surveyed country – the territorial bias score – is developed. Second, a detailed horizontal
323
Territorial bias
in prudential
supervision
and regulation

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