Regulatory Arbitrage and Cross‐Border Bank Acquisitions

• Date: 01 December 2015
• DOI: http://doi.org/10.1111/jofi.12262
• Published date: 01 December 2015

THE JOURNAL OF FINANCE •VOL. LXX, NO. 6 •DECEMBER 2015

Regulatory Arbitrage and Cross-Border Bank

Acquisitions

G. ANDREW KAROLYI and ALVARO G. TABOADA∗

ABSTRACT

We study how differences in bank regulation influence cross-border bank acquisition

flows and share price reactions to cross-border deal announcements. Using a sample

of 7,297 domestic and 916 majority cross-border deals announced between 1995 and

2012, we find evidence of a form of “regulatory arbitrage” whereby acquisition flows

involve acquirers from countries with stronger regulations than their targets. Target

and aggregate abnormal returns around deal announcements are positive and larger

when acquirers come from more restrictive bank regulatory environments. We inter-

pret this evidence as more consistent with a benign form of regulatory arbitrage than

a potentially destructive one.

THE RECENT GLOBAL FINANCIAL crisis, caused in part by systemic failures in bank

regulation (Levine (2012)), has sparked, among other things, a strong push for

both stricter capital requirements and greater international coordination in

regulation. For example, 7 of the 10 recommendations of the 2011 Report of

the Cross-Border Bank Resolution Group of the Basel Committee for Bank-

ing Supervision (BCBS) propose greater coordination of national measures to

deal with the increasingly important cross-border activities of banks.1A cost

∗Karolyi is with Johnson Graduate School of Management, Cornell University and Taboada is

with Haslam College of Business, University of Tennessee. We received helpful comments from

the Editor, Kenneth J. Singleton, three anonymous referees, Warren Bailey, Leonce Bargeron,

Jim Booth, Alex Butler, David Chor, Stijn Claessens, Werner DeBondt, Larry Fauver, Matt Har-

ris, Jay Hartzell, Tom Jacobs, Jan Jindra, Ed Kane, Oguzhan Karakas, Dong-Wook Lee, Edith

Liu, Qingzhong Ma, Dalia Marciukaityte, Yuki Masujima, Pamela Moulton, Luc Renneboog, Ste-

fano Rossi, Klaus Schaeck, Merih Sevilir, Parul Sharma, Joao Santos Silva, Elvira Sojli, Silvana

Tenreyro, Neeltje van Horen, Xinli Wang, Tracie Woidtke, and Chu Zhang. We also thank partici-

pants at the 2012 EFA meeting (Copenhagen, Denmark), 2011 Asian FMA meetings (Queenstown,

New Zealand), Bocconi University’s 2012 CAREFIN conference on The Effect of Tighter Regula-

tory Requirements on Bank Profitability and Risk-TakingIncentives (Milan, Italy), Baruch College,

Boston College, Cambridge, Cornell, Cyprus, the Office of the Comptroller of the Currency,DePaul,

EPFL-HEC Lausanne, Erasmus, IMF, Ohio State, North Carolina, Pittsburgh, Tennessee, Texas–

Austin, Tilburg, and the World Bank. Jonathan Jones, Dilip Patro and their colleagues at the OCC

greatly enriched our understanding of bank regulation. Ronnie Chen provided helpful research

assistance. All remaining errors are, of course, our own. This paper previously circulated under

the title: “The Role of Regulation in Cross-Border Bank Acquisitions: Is It Really a ‘Race to the

Bottom’?” The authors do not have any conflicts of interest, as identified in the Disclosure Policy.

1The group was approved by the BCBS in December 2007, but its report originated with the

G20 communiqu´

e of April 2009 and the follow-up G20 Working Group on Reinforcing International

DOI: 10.1111/jofi.12262

2395

2396 The Journal of Finance R

of centralizing bank regulation across countries is that it limits cross-country

regulatory competition to the extent that a fully harmonized global regula-

tion imposes uniform standards across countries (Acharya (2003), Dell’Ariccia

and Marquez (2006)). A benefit, however, is that it internalizes any interde-

pendencies that exist across countries due to the integration of their financial

systems. Indeed, the push for stricter regulations has been driven in large part

by concerns about one such interdependency, namely, an increase in the risk of

“regulatory arbitrage,”2whereby banks from countries with strict regulations

engage in cross-border activities in countries with weaker regulations.

There are two views on the consequences of regulatory arbitrage. On the

one hand, banks engaging in regulatory arbitrage can maximize shareholder

value and improve capital allocation if such activities occur when banks are

constrained from pursuing profitable investment opportunities due to costly

regulations in their home country. These benefits may accrue not just to the

acquirer, but also to the target, which may benefit from “bonding” to a more

robust regulatory regime after being acquired by banks from countries with

stronger supervision.3On the other hand, banks engaging in regulatory arbi-

trage can pursue value-destroying activities through excessive risk-taking, for

example, by acquiring targets in countries with lax regulations and weak su-

pervision. This form of regulatory arbitrage could have adverse consequences

for bank performance and shareholder value, not only for the parties to the deal

but also for the banking system as a whole, and could even be a catalyst for a

harmful “race to the bottom” in bank regulations.4Regulatory arbitrage of this

harmful form may be especially dangerous as it can increase the fragility of

interconnected financial systems around the world if the acquiring banks can

extract subsidies from the host country’s regulator, central bank, or taxpayers

for losses from its more weakly monitored risk exposures.5

Cooperation and Promoting Integrity in Financial Markets, which became a permanent initiative

in the form of the Financial Stability Board. The BCBS, as a forum for regular cooperation on

banking supervisory matters, has been in existence since 1974 and reached prominence with the

Basel Capital Accords in 1988.

2BCBS member Jos´

eMar

´

ıa Rold´

an stated at the Asian Banker Summit in Hong Kong in April

2011, “If we have higher capital requirements, we are going to have higher incentives for regulatory

arbitrage. Within banks, across banks, across countries, if you have an uneven application of Basel

III you will see banking activity going to the country that has a softer approach.”

3The bonding hypothesis (Coffee (1999), Stulz (1999)) has been widely documented in the cross-

listing literature (see, e.g., Doidge, Karolyi, and Stulz (2004)). Bonding could happen through

tougher discipline imposed by stronger regulatory authorities from the acquirer’s home country

for the newly consolidated entity. This is similar to bonding in the cross-border M&A literature

whereby the target firm usually adopts the governance structures of the country of the acquiring

firm (Rossi and Volpin (2004), Bris and Cabolis (2008), Ellis et al. (2012), Starks and Wei(2013)).

4By engaging in cross-border bank acquisitions in countries with weaker regulations, acquirers

may also extract safety-net subsidies from home country regulators. We thank Edward Kane for

providing this alternative interpretation.

5Acharya (2003) models how international convergence of bank capital requirements can lead to

an unintended race-to-the-bottom equilibrium if not accompanied by consistent resolution policies

across regimes. Banks that operate across borders will undertake greater risk in more forbearing

regimes, which reduces bank profits in less forbearing regimes and forces those banks to exit. All

Regulatory Arbitrage and Cross-Border Bank Acquisitions 2397

In this paper, we shed light on the motives behind regulatory arbitrage

by examining one of the most important types of investment decisions that

banks can make—cross-border acquisitions. Cross-border deals are a particu-

larly useful setting to evaluate the effects of regulatory restrictions not only

because the acquiring banks can escape some of the regulatory restrictions in

their home country by acquiring institutions in weaker regimes but also be-

cause of the enormous growth in bank consolidation—domestic and especially

cross-border—facilitated by major regulatory changes around the world.6We

increase, the power of our tests by controlling for other motives for bank acqui-

sitions, such as efficiency,market power, as well as governance-related motives,

and by benchmarking against purely domestic deals. To the best of our knowl-

edge, ours is the first study to examine regulatory arbitrage in cross-border

bank acquisitions on a global basis.

Our sample of 7,297 domestic and 916 majority cross-border deals is cumu-

latively valued in excess of $2.8 trillion involving acquirers and targets from

78 countries over the period 1995 through 2012. We first evaluate how dif-

ferences in regulations influence the volume of cross-border bank acquisitions

and the flow of deal activity between the home countries of the bank acquir-

ers and targets to determine whether the flows are in line with regulatory

arbitrage. We next examine the impact of differences in bank regulation on

shareholder wealth as measured by the short-run stock price reactions of the

acquirer and target banks to deal announcements. Finally, we examine how

changes in merger control policy influence both cross-border bank acquisitions

and the potential impact of differences in bank regulations on those flows.

Cross-border acquisitions are, of course, just one way in which banks can en-

gage in regulatory arbitrage. But examining such deals allows us to disentangle

whether regulatory arbitrage activities represent the pursuit of excessive

risk-taking or the more benign escape from costly regulations by controlling for

deal- and bank-specific attributes in addition to country-level factors. We

hypothesize that, for banks that are more likely to engage in value-destroying

regulatory arbitrage through cross-border acquisitions (the race-to-the-bottom

view), we should observe an adverse market reaction to cross-border acqui-

sitions from good to weak countries, all else being equal.7In addition, to

the extent that regulatory arbitrage of this form drives cross-border bank

regulators therefore converge on the worst level of forbearance, which destabilizes the banking

system. Similar models include Dell’ Ariccia and Marquez (2006), Morrison and White (2009),

and Agarwal et al. (2012). Acharya, Wachtel, and Walter (2009)discuss how regulatory arbitrage

activities might expose all jurisdictions to the influence of excess risk-taking.

6Examples include the 1999 Gramm-Leach-Bliley Financial Services Modernization Act in the

United States that overturned the Glass Steagall Act of 1933, which had separated commercial

from investment banking activities; the Federal Reserve’sRegulation K that reduced the regulatory

burden on foreign banks operating in the United States (final amendment in October 2001); and

the 1989 Second Banking Directive in the European Union (EU) that created a single banking

license valid throughout the EU.

7Although a race to the bottom is the outcome of regulatory choices associated with the harmful

motive for cross-border bank acquisitions, for simplicity we use the term “race to the bottom” to

refer to the harmful form of regulatory arbitrage.