VoxEU Column Macroeconomic policy

Regulatory arbitrage in action: Evidence from cross-border lending

Regulatory arbitrage is an essential feature of modern banking. This column presents new evidence on avoiding macroprudential policies by borrowing from abroad. Domestic non-banks borrow more from abroad after an increase in capital requirements, but not after an increase in lending standards. This is most likely because of differences in the way the two regulations apply, and suggests that we should have strong frameworks for reciprocating capital regulation.

Following the Global Crisis, macroprudential policies have become part of many central banks' toolkits. These instruments are being actively used to address cyclical and structural risks within financial systems – and as such, there has been extensive debate about the use of different instruments for different microprudential and macroprudential objectives.

There is a recent and rapidly expanding literature on the effects of macroprudential instruments (Lim et al. 2011, Vandenbussche 2012, Classens et al. 2013, Kuttner and Shim 2013). But the effectiveness of these instruments may be compromised if banks and borrowers are able to avoid these measures via regulatory arbitrage or if the regulation is subject to ‘leakages’ whereby the activity migrates to institutions that are not covered by the instruments.

Much of the debate over leakages has focused on lending by ‘shadow banks' or non-bank financial institutions, but another kind of regulatory leakage stems from internationally active banks. Some macroprudential instruments – in the absence of reciprocal arrangements – cannot be applied to all financial institutions within a country. As an example, capital regulation may apply unevenly as foreign branches and cross-border lending are not necessarily subject to the same regulatory measures as domestically-regulated banks. In contrast, product regulation, such as placing a limit on the maximum loan-to-value mortgage a household can get, usually applies to all products sold in a particular country.

Differences in regulation are a significant driver of cross-border banking, as banks expand lending to countries with lower regulatory standards (Houston et al. 2013, Ongena et al. 2013). Aiyar et al. (2012) examine the issue of leakages for time-varying in minimum capital requirements in the UK and find that foreign branches can be a considerable source of ‘leakage’ as they expand their lending into the UK after an increase in UK banks’ capital requirements because they are not subject to the capital requirements. We examine whether these leakages apply to a broad range of macroprudential instruments in a cross-country study (Reinhardt and Sowerbutts 2015).

To examine the question of different instruments, we use a new database on macroprudential policies This database builds on the work by Lim et al. (2011) and Kuttner and Shim (2012), but continues to update their work to 2014 by hand-collecting data from regulators’ websites, financial stability reports and communication with relevant authorities. This allowed us to build a dataset containing information on a wide range of macroprudential policy actions in 70 countries over the period 1990 to 2014. Time series data of capital and lending standards actions, which are the main focus of this paper, are illustrated in the figures below.

Figure 1. Capital tightening and capital loosening

Figure 2. Lending standards tightening and loosening

We group together applications which are similar in terms of their regulatory application, so for example all risk weight and capital requirement actions are combined to create the variable ‘capital'. Similarly, actions such as limits on loan-to-value ratios, debt service ratios and repayment periods are grouped as ‘lending standards', given that these all apply to borrowers, are introduced via the same framework of regulations and are frequently taken at the same time.

To examine potential leakages, we examine how non-bank borrowing from foreign banks – using the UK Department for Business, Innovation and Skills (known as ‘BIS’) consolidated banking statistics – changes after that country’s authorities take a macroprudential action. We estimate tightening and loosening effects separately. We include a number of controls including domestic credit growth, as by controlling for the domestic credit cycle, we focus our attention on changes in foreign bank lending growth over and above changes in domestic credit growth, such as lending driven by changes in the relative competitive advantage of foreign banks vis-à-vis domestic banks.

We include sending country fixed effects to capture all factors external to the country implementing the macroprudential policy. Our coefficients hence capture changes in foreign bank lending growth driven by domestic factors of the country taking the macroprudential policy action.

We are agnostic about the time-period over which macroprudential policy may affect banking flows and so we vary the lag structure of the ‘macroprudential’ variable to let macroprudential actions affect borrowing from foreign banks over different time horizons.  

Figure 1 below illustrates plots the coefficients of our regressions. In our baseline specification we find that neither a tightening nor loosening in lending standards is associated with an increase in borrowing from foreign banks. However, we document evidence for leakages: a tightening in capital requirements is associated with an increase in borrowing from foreign banks as a typical capital tightening event leads to an increase in the growth rate of borrowing from abroad – although a loosening in capital requirements is not significant.

Figure 3. Lending standards, reserve requirements and capital tightening and loosening

The figure plots the regressions coefficient of macroprudential policy dummies on non-bank borrowing from foreign banks and their confidence intervals for various options for the lag structure on these dummies (and conditioning on other factors).

The results suggest that a tightening of capital regulation induces domestic non-banks to increase their borrowing from foreign banks, while a tightening of lending standards does not have the same effect, which suggests that uneven application of bank capital regulation may be a driver of international banking flows. This is over and above the effect, which has been documented extensively in the literature mentioned above, where banks transfer funds to markets with fewer banking regulations. Our results show a subtle contrast – banks transfer funds to countries that tighten regulatory standards, but transfer these funds when the regulatory tightening does not apply to them, and instead confers upon them a competitive advantage.

Authorities are able to apply capital regulation to subsidiaries that they supervise, but not branches. This suggests that leakages should occur via branches. By accounting for measures of the relative of importance of branches versus subsidiaries taken from Fiechter et al. (2011), we show that the evidence on leakages is indeed stronger for banking systems where foreign affiliates are mainly organised as branches.

Our results also suggest that instrument choice matters for the effectiveness of macroprudential policy. Indeed, some of the results in the literature – which focuses on the domestic effects – may be influenced by how open and subsidiarised the country's banking system is, and the fact that currently reciprocity arrangements only apply to the countercyclical capital buffer. Our research is supportive of building strong reciprocity frameworks with a high degree of automaticity as the leakage occurs soon after the action is taken.

It is a welcome fact that reciprocity of the countercyclical capital buffer is a cornerstone of Basel III, and EU law requires automatic reciprocation of CCB rates from 2016. These rules do not, however, proscribe rules for all potential macroprudential instruments. The results presented in here suggests that there are also likely to be leakages with regard to other capital and liquidity-like policies suggesting that there may be benefits from extending the principle of reciprocity further. At the European level, assessing the cross-border impact of macroprudential policies and coordinating member states' actions is at the heart of the mandate of the European Systemic Risk Board. Capital rules (CRD IV/CRR), which have been in force since 1 January 2014, already foresee some coordination procedures involving the European Systemic Risk Board for specific instruments. But more work needs to be done on working out an optimal and feasible reciprocation and coordination strategy.


Aiyar S, C Calomiris and T Wieladek (2012). “Does macropru leak? Evidence from a UK policy experiment”, NBER Working Papers 17822.

Claessens S, R S Ghosh and R Mihet  (2013), "Macro-prudential policies to mitigate financial system vulnerabilities", Journal of International Money and Finance 39(C): 153-185.

Fiechter J, I Otker-Robe, A Ilyina, M Hsu, A Santos and J Surti (2011), “Subsidiaries or branches: Does one size fit all?”, IMF Working Papers 11/04.

Houston J F, C Lin and Y Ma (2012), “Regulatory Arbitrage and International Bank Flows”, Journal of Finance 67(5): 1845-1895.

Kuttner, K N and I Shim (2013), “Can Non-Interest Rate Policies Stabilize Housing Markets? Evidence from a Panel of 57 Economies,” NBER Working Papers 19723, National Bureau of Economic Research, Inc.

Lim C C, P Costa, P Kongsamut, A Otani, M Saiyid, T Wezel and X Wu (2011), “Macroprudential policy: What instruments and how to use them?”, IMF Working Papers 11/238.

Ongena S, A Popova and G F Udell (2013), “When the cat's away the mice will play: Does regulation at home affect bank risk-taking abroad?”, Journal of Financial Economics 108 (3): 727-750.

Reinhardt, D and R Sowerbutts (2015), “Regulatory arbitrage in action: evidence from banking flows and macroprudential policy”, Bank of England Staff Working paper no 546.

Vandenbussche J, U Vogel and E Detragiache (2012), “Macroprudential Policies and Housing Prices – A new database and empirical evidence for Central, Eastern and Southeastern Europe”, IMF Working Papers 12/303, International Monetary Fund.

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