Regulatory arbitrage behavior of internationally active banks and global financial market conditions

Abstract

Existing research has documented that tighter regulation tends to restrain banking activity.Nevertheless, the extent to which this effect depends on global financial conditions is relatively unknown. This paper identifies two theoretical mechanisms that relate the regulatory arbitrage behavior of internationally active banks (IABs) to global financial conditions. According to the first mechanism, regulation becomes more binding during adverse global financial conditions and IABs face higher compliance costs in more regulated markets. According to the second mechanism, regulation suppresses the degree of risk-taking so that highly-regulated countries are more insulated from global financial risk. Using the BIS international banking statistics and a unique empirical strategy, we find that the first mechanism is more prevalent. IABs expand their claims on less-regulated countries more rapidly when global financial conditions are tight. However, the relationship goes in the opposite direction under loose global financial conditions. Structural vector autoregressive estimations at the country level provide supporting evidence.