Description
This paper aims to discuss factors that affect the socially optimal jurisdiction of financial
supervision in the presence of economies of scale in banking.
Journal of Financial Economic Policy
Optimal jurisdiction of financial supervision
Tom Patrik Berglund
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Tom Patrik Berglund , (2013),"Optimal jurisdiction of financial supervision", J ournal of Financial Economic
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Optimal jurisdiction of
?nancial supervision
Tom Patrik Berglund
Hanken School of Economics, Hanken Centre for Corporate Governance,
Helsinki, Finland
Abstract
Purpose – This paper aims to discuss factors that affect the socially optimal jurisdiction of ?nancial
supervision in the presence of economies of scale in banking.
Design/methodology/approach – Analysis of the trade-off between likelihood of “regulatory
capture” of supervisors in a small jurisdictions and bene?ts of greater rates of ?nancial innovation in a
less-bureaucratized and more diverse supervisory organization.
Findings – The challenge is to create a ?nancial supervisory institution that should be powerful
enough to close down even the largest ?nancial institutions within its jurisdiction, while at the same
time not becoming so large and omnipotent that it would sti?e further development of ?rms in
?nancial services.
Research limitations/implications – Deeper understanding of minimum ef?cient scales in
?nancial intermediation required, and of regulatory capture vs ef?cient information acquisition from
regulated units.
Practical implications – Basis for international (regional) cooperation in facilitating ef?cient
delivery of ?nancial services, in particular in smaller countries.
Originality/value – Developments in information technology have fundamentally changed the
ways ?nancial intermediaries operate paving the way for giant units that in key areas are able to
outcompete smaller business units. The ?nancial crisis that started in 2008 revealed that these large
and interconnected organizations are in a position to extract implicit subsidies from the rest of the
society. The organization of ?nancial supervision must adapt to these changing conditions.
Keywords Banks, Financial supervision, Optimal jurisdiction, Government policy and regulation
Paper type Research paper
1. Introduction
The global ?nancial crisis that erupted in 2008, the consequences of which we still
experience, has generally been interpreted as evidence that there is a need to redesign
the global ?nancial system to make it more robust against similar future shocks.
Perhaps the most important lesson from the early stage of the crisis was that a single
?nancial institution can be so big and interconnected that its failure can result in very
costly repercussions for the rest of the economy. The uncertainty created by the
decision to let Lehman Brothers declare bankruptcy almost brought the world
economy to a standstill in the fall of 2008.
The general perception that the decision to let Lehman Brothers fail was an event
that triggered a severe aggravation of the crisis has reinforced the view that large and
well connected ?nancial institutions should not be allowed to fail. However, an implicit
commitment – just as an explicit one – not to allow some ?nancial institutions to fail
will lead to an externality from ?nancial institutions’ point of view. The reason is the
The current issue and full text archive of this journal is available at
www.emeraldinsight.com/1757-6385.htm
JEL classi?cation – G21, G28
Journal of Financial Economic Policy
Vol. 5 No. 4, 2013
pp. 405-412
qEmerald Group Publishing Limited
1757-6385
DOI 10.1108/JFEP-07-2013-0029
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subsidy, to materialize in a severe crisis, that this commitment implies. Thus, total
expected marginal costs of risk taking by large banks from the society’s point of view
may be substantially higher than the costs that the bank itself is expected to cover.
In other words, if the costs for handling the crisis are born by the government, and thus
ultimately by taxpayers, there will be incentives for excessive risk-taking by crisis
prone ?nancial institutions, as well as incentives for smaller ?nancial institutions to
increase their size to become large enough to receive this implicit subsidy.
The discussion of how to avoid similar disasters as the one in 2008-2009 in the
future has largely focused on how to address this externality[1]. Well known from
standard micro economics externalities should ideally be handled by imposing explicit
costs on the ?rms that produce this externality, costs that should be large enough to
restore the right balance between true marginal costs for the society and the marginal
bene?ts that accrue to the individual ?rm.
A number of proposals for how to do this have been discussed. Typically they refer
to different kinds of restrictions that will make it more costly for ?nancial institutions
to become more complicated, that is to become so-called Systemically Important
Financial Institutions (SIFIs).
Barth and Prabha (2013) list ?ve different types of measures that have been
discussed that could alleviate the too-big-to-fail (TBTF) problem:
(1) a cap on bank size;
(2) splitting up SIFIs: into functionally separate units;
(3) requiring larger capital buffers at SIFIs;
(4) improvements in the framework of handling collapses of SIFIs; and
(5) a combination of the above.
As noted by Barth and Prabha (2013) all of these categories of proposals have their
shortcomings, and none of them are guaranteed to bring large enough expected
bene?ts in terms of reduced likelihood for a devastating crisis to clearly offset added
costs of administration, enforcement and ef?ciency reducing distortions.
Still, there exists general agreement that the regulatory framework for ?nancial
intermediation should be amended with rules that are likely to be more ef?cient in
preventing large-scale crises from erupting. In addition to crafting of better rules,
however, the enforcement of these rules must not be neglected. A number of cases
during the last ?nancial crisis and its aftermath, Iceland being perhaps the most
obvious case[2], revealed that the local authority in charge of the enforcement simply
lacked “?repower” to step in and safeguard that existing rules were properly followed.
This paper will not focus on the rules as such, mainly because they have been so
extensively discussed elsewhere[3]. Even if there may exist some arguments for
implementing different sets of rules in different parts of the world[4] the geographical
dimension is less important for how the rules should be designed than for their
enforcement. The focus of this paper will thus be on aspects that should be taken into
account when deciding on the optimal degree of cross-border centralization versus
decentralization in enforcement of ?nancial regulation.
The paper proceeds as follows: Section 2 focuses on the extension of the jurisdiction of
?nancial supervisionbeyondnational borders as a more andmore urgent issue. One aspect
of this issue is the home versus host country dilemma. General principles for determining
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an ideal extension of the jurisdiction for supervision of ?nancial services are discussed in
this section. Section 3 introduces political economy aspects of optimal jurisdiction.
In particular, technology driven scale economies and the phenomenon of regulatory
capture may justify extensive jurisdictions. The counteracting threat favouring more
restricted jurisdictions is the creation of a sti?ing bureaucracy, a threat that will favour
more restricted jurisdictions. The concluding Section 4 summarizes the arguments.
2. Optimal jurisdiction in banking: economic arguments
In the following, I will assume that exactly the same rules will apply within one and the
same jurisdiction, which is the territory over which the same supervisory institution
carries authority. The fundamental reason why the issue of jurisdiction has become
more important recently is advances in information and communication technology.
These advances produce increased scale advantages for two reasons. First, computers,
and in particular the software that run on these computers, have become more and
more sophisticated. Computers have thus taken over an ever-increasing part of
mechanical tasks from employees in ?nancial services. Computer software, by its very
nature, is expensive to develop but cheap to run once it has been properly tested. Since
the same software then can be used as such to serve additional customers at practically
no additional costs a larger number of customers will lead to lower costs per customer.
Thus, scale has become ever more important for pro?table operations in ?nancial
services. Second, the falling communication costs allows for cheap ways to keep track
of transactions that take place around the world. For this reason it is now possible to
run properly global operations in a relatively tightly knit unit.
Alarge number of empirical studies have been made on ef?ciency in banking, and on
whether there are scale related differences in ef?ciency. A substantial part of these
studies have been done on US data[5]. Earlier studies on data up to the 1980s did not ?nd
evidence of scale economies for but the smallest banks. However, empirical studies on
later data have found evidence of economies of scale for bank sizes up to the largest ones
that can reliably be covered with statistical methods. Thus, Wheelock and Wilson (2012)
report scale economies for banks with up to $1 trillion in assets[6]. In a study on banks
with assets above $100 billion, Hughes and Mester (2011) ?nd scale-economies that
seem, if anything, to increase with bank size. A general problem in these studies is
obviously that information technology has not only impacted the costs of delivering
services that banks traditionally have sold to their customers but also drastically
expanded the whole set of services that banks are able to offer to their corporate
customers.
Given the cost advantage of larger scale inmany areas of banking, national borders of
small countries, in particular, became too restrictive a long time ago. Thus, commercial
banks have established operations in foreign countries since way back in time. As long
as the foreign operations remained modest compared to domestic operations the
challenge for supervision was negligible. However, when foreign operations begin to
overshadowdomestic ones the problemof the appropriate jurisdiction that should guide
the banks activities becomes important: should it be the authorities in the country
where the ?nancial institution is headquartered (home country) or should it be the
authorities in the country where the institution operates (host country)?
The problem in having the home country doing the supervision is that the home
country supervisors may lack the “?re power” to tackle a ?nancial institution that has
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grown too big. Principled individuals at the supervisory authority that try to hold back
on attempts by the existing large ?rms to become even more powerful, will simply ?nd
themselves replaced by more cooperative individuals from the banks’ standpoint, since
the managers of the supervised large banks know which “levers” to pull since the
large bank is well networked in its small home country due to its involvement in most
large restructurings that take place in that country.
Attempts to keep all control on the host country level, on the other hand, will
prevent access to scale advantages in small countries and will ultimately make
?nancial intermediation more expensive in small countries than in larger ones[7].
The main underlying argument in favour of more extensive jurisdictions in ?nancial
supervision is economies of scale in important banking activities[8]. Advances in
information processing and storage technology, which continuously reduce hardware
costs, shift the emphasis to software production in which development costs dominate.
At the same time, the on-going rapid reduction in communication costs reduce the
coordination costs that previously made extensive global operations expensive.
Due to these on-going trends the future of ?nancial intermediation will be characterized
by increasing scale advantages. In particular this is likely to hold in commercial
banking that serves customers who themselves run cross border businesses.
Obviously a supervisory authority with a mandate that is geographically much
more limited than the operations of the ?rms they supervise will have some dif?culties
in exercising its authority over the supervised units. Thus, there is a good case for
increasing the extension of the jurisdiction for the supervisory authorities to match the
growth in size of economically ef?cient ?rms in ?nancial services.
A counterargument against increasing the size of jurisdictions in ?nancial
supervision is that more extensive jurisdictions imply larger average distances
between the central supervisory authority and the ?nancial institutions that fall under
its mandate. A larger distance is likely to make monitoring more dif?cult and thus
increase the likelihood of a chain of events that will go undetected until it is too late to
prevent a disastrous outcome. However, potential advantages of geographic
proximity between supervisor and supervised should be handled by appropriate
decentralization of the monitoring activities, not by trying to preserve overly restricted
jurisdictions.
A more serious drawback, similar to the one that forms the basis for the argument
that Romano (2012) has advanced against harmonization of ?nancial regulation, is that
if there are fewer jurisdictions globally – which must be the case if they are larger –
there will be less of regulatory competition, and if there is less competition the risk that
the ?nancial sector gets stuck with obsolete regulation will increase.
The problem with this argument is that competition in ?nancial regulation is
unlikely to be very ef?cient from a social point of view in any case. A large number of
other factors than legal rules and regulations vary between countries belonging to
different jurisdictions and will thus have an impact on the outcome of the competition
between the countries. The enforcement of existing regulation will also most likely
vary from one country to another. Exactly the same rules may apply but if they are
strictly enforced in one jurisdiction but not in the other there will be a major difference
between the countries. Because of all other factors that make regions different, it will be
extremely dif?cult to judge weather one set of rules in ?nancial supervisions has
outperformed another set of rules, or vice-versa. Since an obvious ranking of the
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ef?ciency of existing supervisory regimes in different geographical areas is dif?cult to
establish, convergence towards better functioning supervisory mechanisms is bound
to take place very slowly, if at all.
3. Political economy aspects on banking supervision
In addition to technology driven scale advantages an endemic problem in ?nancial
supervision is what is commonly called regulatory capture[9]. This problemis important
in trying to establish the appropriate extension of the jurisdiction of supervisory
authorities. Regulatory capture is the phenomenon that regulators start to identify
themselves with the objects for the regulation. This can take blatant forms, like a
supervised unit trying to bribe off of?cials that are in charge of the supervisory activities,
but regulatory capture will also occur well within the limits provided by the law.
The reason why regulatory capture is so dif?cult to weed out completely from
?nancial supervision is that regulatory capture is closely related to requirements for
making monitoring of ?nancial institutions as ef?cient as possible. For monitoring to
be ef?cient those who are conducting it must have access to timely and accurate
information and a relatively deep understanding of the business. Since supervisory
authorities usually are less well informed than the persons they supervise, i.e. those
who are in charge of running the supervised activity, supervisors can improve their
access to information if they are on friendly terms with people close to the source of the
information, that is, if they are on friendly terms with those who run the business.
“being on friendly terms” again must build on some form of empathy that may be
misused by those who are subject to the monitoring activity.
In setting up appropriate regulation it is important to recognize the impossibility of
drawing a strict line between what is likely to result in harmful regulatory capture on
one hand, and what is desirable as a result of a smoother ?ow of relevant information
from supervised units to the supervisor on the other. Any attempts to draw such lines
by establishing strict rules will only result in expensive resources being wasted on
different ways to circumvent the rules. To make monitoring as ef?cient as possible the
persons that are in charge of the monitoring should instead be given the freedom to
behave in a non-predictable way every once in a while.
Due to regulators’ frequent need for high quality information regulatory capture will
remain a potential problem even in otherwise ef?cient jurisdictions. Some cases where
excessive regulatory capture is highly likely to become a major problem can easily be
identi?ed. These are cases where the regulators personal wealth will be dependent on
whether the regulated unit is allowed to continue with its operations or not. In those
cases there is an obvious danger that the regulator may end up in a situation where
“sounding the bell” on reckless risk-taking will be avoided at all cost: better to stay put
and hope for the best. Small jurisdictions will be more exposed to this danger than large
jurisdictions. In large jurisdictions the supervising authority has a larger number of
supervised business units to take care of. Thus, a forced liquidation of one of the units
will not eliminate the jobs for those who personally are in charge of the supervision of
that unit.
The simple principle that this leads to is that the jurisdiction in ?nancial supervision
should be extensive enough not to give rise to natural monopolies in any important
business area that the ?rms within the jurisdiction are involved in. Since natural
monopolies arise when average costs decrease beyond business volumes that cover
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the whole market, that is where scale economies exist even for the biggest ?rms in
the jurisdiction. This principle implies that the size of the jurisdiction should be
determined on the basis of minimumef?cient scales in the ?nancial services industry[10].
As discussed in Boyd and Heitz (2011) and Davies and Tracey (2012) the question of
scale economies in banking activities is likely to be more problematic than in other
areas. The reason is that the implicit subsidy produced by the TBTF phenomenon
will be a signi?cant part of the scale advantages for the largest banks[11]. However, for
conclusions concerning an optimally sized jurisdiction any scale advantages due
TBTF phenomenon will even more strongly call for large enough jurisdictions,
provided that the regulators can be con?dent that the immediate losses if a large
?nancial institution has to be closed down and resolved can properly be handled within
that jurisdiction[12].
To confer the supervisory authority on an institution with a large enough
jurisdiction will not be suf?cient to address the TBTF problem, though. Even if –
based on purely technical factors – there is scope for a relatively large number of
?nancial institutions operating at minimum ef?cient scale within the relevant
jurisdiction there must still be enough of disincentives for each ?nancial institution to
offset any TBTF funding advantages that an individual ?rm might be able to obtain by
increasing their scale far beyond what would be justi?ed from a purely technological
point of view. However, preventing individual players from becoming too dominant is
precisely the challenge that competition authorities are facing in other industries too.
4. Conclusions
This paper discusses factors that have an impact on the optimal size of the jurisdiction
of the supervisory authorities under which a ?nancial institution is operating.
The need to carefully tackle this issue stems from the fact that an ever-larger number
of ?nancial institutions have signi?cant operations abroad. Thus, supervision on a
national level will either fail to cover most of the ?nancial institution’s activities or the
multinational ?nancial institution will be subject to overlapping supervision from a
number of national supervisors.
To address this problem strict coordination between national supervisors is
required or a cross-border jurisdiction has to be introduced. In this paper the latter
alternative has been discussed.
The most important factor that calls for more extensive jurisdictions than the
present ones is economies of scale in many areas of banking business. As technology
develops, sophisticated software that deliver solutions even to relatively complicated
problems faced by customers, in a customer friendly way, will become ever more
common in the banking business. Since software costs are largely development costs
having access to a large customer base will become increasingly important. A large
customer base allows distribution of the largely ?xed, development costs on a large
number of individuals. Reduced communication costs are simultaneously reducing
the coordination costs that traditionally have been the main reason for observing
disadvantages to scale beyond certain sized organizations.
Since large organizations will have a cost advantage relative to small ones it will be
costly to try to prevent ?nancial institutions frombecoming large enough to fully exploit
that advantage. To safeguard that the supervisors who are in charge of monitoring these
big ?rms will not too easily become subject to regulatory capture the supervisory
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jurisdiction that these large ?rms operate in has to be extensive enough to encompass a
number of such large ?rms. A supervisory authority that has one or two really large
?nancial institutions to monitor will be too dependent on these institutions to be able to
act independently. Such an authority will not be able to credibly uphold the main threat
that makes ?nancial institutions comply with the regulation, that is the threat of closing
down the ?rm that has mismanaged its assets and liabilities.
Notes
1. See the report of the High-level Expert Group on Reforming the Structure of the EU Banking
Sector (2012).
2. See Buiter and Sibert (2008).
3. See in particular Barth and Prabha (2013) but also the general discussion in
Brunnermeier et al. (2009).
4. Including the need for experimentation, that is allowing different sets of rules to compete in
practice (Romano, 2012) to establish whether some of them are preferable to others.
5. An extensive survey of early studies can be found in Berger and Humphrey (1997). For a
knowledgeable discussion of advances and challenges in the research on scale economies in
banking, see Mester (2008).
6. Up to assets of $1.5 trillion in Feng and Serilitis (2009).
7. Keeping the control at the host country level implies that foreign banks have to operate as
independent subsidiaries whereas if the control is maintained on the home country level the
bank can simply set up branches in the foreign country. For a discussion of the different
aspects involved see Luciano and Wihlborg (2013).
8. A number of researchers, however, claim that the implicit subsidy from the “too big to fail”
phenomenon is the most important component in the advantages to scale in modern
banking. See Boyd and Heitz (2011).
9. See Stigler (1971). An interesting discussion of the need to split up ?nancial supervision
between different organizations to counteract regulatory capture can be found in Boyer and
Ponce (2012).
10. The above arguments imply that the optimal size of the jurisdiction will most likely grow
over time. Sophisticated software will become ever more important in ?nancial services
tilting the costs structure towards higher ?xed costs, and reducing the coordination costs
that tend to increase costs on the margin in any organisation.
11. Davies and Tracey (2012) conclude that in their sample of 172 large banks (assets above
50 billion USD), no signi?cant economies of scale when TBTF funding advantages are left
out. However, when the implicit subsidy from assumed TBTF status is taken into account
there are scale advantages for the banks in this sample.
12. Since the decision to close down a ?nancial institution must be taken quickly so as to avoid a
situation where the banks business partners start to “scramble for the exit” their must be a
sizeable enough “resolution fund” in the form of irrevocable commitments from the countries
that share the same supervisory jurisdiction.
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Mester, L.J. (2008), “Optimal industrial structure in banking”, in Boot, A. and Thakor, A. (Eds),
Handbook of Financial Intermediation, North-Holland, Amsterdam, pp. 133-162.
Romano, R. (2012), “For diversity in the international regulation of ?nancial institutions”,
working paper, Yale Law School, New Haven, CT.
Stigler, G.J. (1971), “The theory of economic regulation”, The Bell Journal of Economics and
Management Science, Vol. 2 No. 1, pp. 3-21.
Wheelock, D.C. and Wilson, P.W. (2012), “Do large banks have lower costs? New estimates
of returns to scale for US banks”, Journal of Money, Credit, and Banking, Vol. 44 No. 1,
pp. 171-199.
Further reading
Haldane, A.G. (2010), “The $100 billion question”, comments given at the Institute of Regulation and
Risk, Hong Kong, available at: www.bankofengland.co.uk/publications/Documents/speeches/
2010/speech433.pdf
Corresponding author
Tom Patrik Berglund can be contacted at: berglund@hanken.?
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doc_412187288.pdf
This paper aims to discuss factors that affect the socially optimal jurisdiction of financial
supervision in the presence of economies of scale in banking.
Journal of Financial Economic Policy
Optimal jurisdiction of financial supervision
Tom Patrik Berglund
Article information:
To cite this document:
Tom Patrik Berglund , (2013),"Optimal jurisdiction of financial supervision", J ournal of Financial Economic
Policy, Vol. 5 Iss 4 pp. 405 - 412
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Optimal jurisdiction of
?nancial supervision
Tom Patrik Berglund
Hanken School of Economics, Hanken Centre for Corporate Governance,
Helsinki, Finland
Abstract
Purpose – This paper aims to discuss factors that affect the socially optimal jurisdiction of ?nancial
supervision in the presence of economies of scale in banking.
Design/methodology/approach – Analysis of the trade-off between likelihood of “regulatory
capture” of supervisors in a small jurisdictions and bene?ts of greater rates of ?nancial innovation in a
less-bureaucratized and more diverse supervisory organization.
Findings – The challenge is to create a ?nancial supervisory institution that should be powerful
enough to close down even the largest ?nancial institutions within its jurisdiction, while at the same
time not becoming so large and omnipotent that it would sti?e further development of ?rms in
?nancial services.
Research limitations/implications – Deeper understanding of minimum ef?cient scales in
?nancial intermediation required, and of regulatory capture vs ef?cient information acquisition from
regulated units.
Practical implications – Basis for international (regional) cooperation in facilitating ef?cient
delivery of ?nancial services, in particular in smaller countries.
Originality/value – Developments in information technology have fundamentally changed the
ways ?nancial intermediaries operate paving the way for giant units that in key areas are able to
outcompete smaller business units. The ?nancial crisis that started in 2008 revealed that these large
and interconnected organizations are in a position to extract implicit subsidies from the rest of the
society. The organization of ?nancial supervision must adapt to these changing conditions.
Keywords Banks, Financial supervision, Optimal jurisdiction, Government policy and regulation
Paper type Research paper
1. Introduction
The global ?nancial crisis that erupted in 2008, the consequences of which we still
experience, has generally been interpreted as evidence that there is a need to redesign
the global ?nancial system to make it more robust against similar future shocks.
Perhaps the most important lesson from the early stage of the crisis was that a single
?nancial institution can be so big and interconnected that its failure can result in very
costly repercussions for the rest of the economy. The uncertainty created by the
decision to let Lehman Brothers declare bankruptcy almost brought the world
economy to a standstill in the fall of 2008.
The general perception that the decision to let Lehman Brothers fail was an event
that triggered a severe aggravation of the crisis has reinforced the view that large and
well connected ?nancial institutions should not be allowed to fail. However, an implicit
commitment – just as an explicit one – not to allow some ?nancial institutions to fail
will lead to an externality from ?nancial institutions’ point of view. The reason is the
The current issue and full text archive of this journal is available at
www.emeraldinsight.com/1757-6385.htm
JEL classi?cation – G21, G28
Journal of Financial Economic Policy
Vol. 5 No. 4, 2013
pp. 405-412
qEmerald Group Publishing Limited
1757-6385
DOI 10.1108/JFEP-07-2013-0029
Optimal
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subsidy, to materialize in a severe crisis, that this commitment implies. Thus, total
expected marginal costs of risk taking by large banks from the society’s point of view
may be substantially higher than the costs that the bank itself is expected to cover.
In other words, if the costs for handling the crisis are born by the government, and thus
ultimately by taxpayers, there will be incentives for excessive risk-taking by crisis
prone ?nancial institutions, as well as incentives for smaller ?nancial institutions to
increase their size to become large enough to receive this implicit subsidy.
The discussion of how to avoid similar disasters as the one in 2008-2009 in the
future has largely focused on how to address this externality[1]. Well known from
standard micro economics externalities should ideally be handled by imposing explicit
costs on the ?rms that produce this externality, costs that should be large enough to
restore the right balance between true marginal costs for the society and the marginal
bene?ts that accrue to the individual ?rm.
A number of proposals for how to do this have been discussed. Typically they refer
to different kinds of restrictions that will make it more costly for ?nancial institutions
to become more complicated, that is to become so-called Systemically Important
Financial Institutions (SIFIs).
Barth and Prabha (2013) list ?ve different types of measures that have been
discussed that could alleviate the too-big-to-fail (TBTF) problem:
(1) a cap on bank size;
(2) splitting up SIFIs: into functionally separate units;
(3) requiring larger capital buffers at SIFIs;
(4) improvements in the framework of handling collapses of SIFIs; and
(5) a combination of the above.
As noted by Barth and Prabha (2013) all of these categories of proposals have their
shortcomings, and none of them are guaranteed to bring large enough expected
bene?ts in terms of reduced likelihood for a devastating crisis to clearly offset added
costs of administration, enforcement and ef?ciency reducing distortions.
Still, there exists general agreement that the regulatory framework for ?nancial
intermediation should be amended with rules that are likely to be more ef?cient in
preventing large-scale crises from erupting. In addition to crafting of better rules,
however, the enforcement of these rules must not be neglected. A number of cases
during the last ?nancial crisis and its aftermath, Iceland being perhaps the most
obvious case[2], revealed that the local authority in charge of the enforcement simply
lacked “?repower” to step in and safeguard that existing rules were properly followed.
This paper will not focus on the rules as such, mainly because they have been so
extensively discussed elsewhere[3]. Even if there may exist some arguments for
implementing different sets of rules in different parts of the world[4] the geographical
dimension is less important for how the rules should be designed than for their
enforcement. The focus of this paper will thus be on aspects that should be taken into
account when deciding on the optimal degree of cross-border centralization versus
decentralization in enforcement of ?nancial regulation.
The paper proceeds as follows: Section 2 focuses on the extension of the jurisdiction of
?nancial supervisionbeyondnational borders as a more andmore urgent issue. One aspect
of this issue is the home versus host country dilemma. General principles for determining
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an ideal extension of the jurisdiction for supervision of ?nancial services are discussed in
this section. Section 3 introduces political economy aspects of optimal jurisdiction.
In particular, technology driven scale economies and the phenomenon of regulatory
capture may justify extensive jurisdictions. The counteracting threat favouring more
restricted jurisdictions is the creation of a sti?ing bureaucracy, a threat that will favour
more restricted jurisdictions. The concluding Section 4 summarizes the arguments.
2. Optimal jurisdiction in banking: economic arguments
In the following, I will assume that exactly the same rules will apply within one and the
same jurisdiction, which is the territory over which the same supervisory institution
carries authority. The fundamental reason why the issue of jurisdiction has become
more important recently is advances in information and communication technology.
These advances produce increased scale advantages for two reasons. First, computers,
and in particular the software that run on these computers, have become more and
more sophisticated. Computers have thus taken over an ever-increasing part of
mechanical tasks from employees in ?nancial services. Computer software, by its very
nature, is expensive to develop but cheap to run once it has been properly tested. Since
the same software then can be used as such to serve additional customers at practically
no additional costs a larger number of customers will lead to lower costs per customer.
Thus, scale has become ever more important for pro?table operations in ?nancial
services. Second, the falling communication costs allows for cheap ways to keep track
of transactions that take place around the world. For this reason it is now possible to
run properly global operations in a relatively tightly knit unit.
Alarge number of empirical studies have been made on ef?ciency in banking, and on
whether there are scale related differences in ef?ciency. A substantial part of these
studies have been done on US data[5]. Earlier studies on data up to the 1980s did not ?nd
evidence of scale economies for but the smallest banks. However, empirical studies on
later data have found evidence of economies of scale for bank sizes up to the largest ones
that can reliably be covered with statistical methods. Thus, Wheelock and Wilson (2012)
report scale economies for banks with up to $1 trillion in assets[6]. In a study on banks
with assets above $100 billion, Hughes and Mester (2011) ?nd scale-economies that
seem, if anything, to increase with bank size. A general problem in these studies is
obviously that information technology has not only impacted the costs of delivering
services that banks traditionally have sold to their customers but also drastically
expanded the whole set of services that banks are able to offer to their corporate
customers.
Given the cost advantage of larger scale inmany areas of banking, national borders of
small countries, in particular, became too restrictive a long time ago. Thus, commercial
banks have established operations in foreign countries since way back in time. As long
as the foreign operations remained modest compared to domestic operations the
challenge for supervision was negligible. However, when foreign operations begin to
overshadowdomestic ones the problemof the appropriate jurisdiction that should guide
the banks activities becomes important: should it be the authorities in the country
where the ?nancial institution is headquartered (home country) or should it be the
authorities in the country where the institution operates (host country)?
The problem in having the home country doing the supervision is that the home
country supervisors may lack the “?re power” to tackle a ?nancial institution that has
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grown too big. Principled individuals at the supervisory authority that try to hold back
on attempts by the existing large ?rms to become even more powerful, will simply ?nd
themselves replaced by more cooperative individuals from the banks’ standpoint, since
the managers of the supervised large banks know which “levers” to pull since the
large bank is well networked in its small home country due to its involvement in most
large restructurings that take place in that country.
Attempts to keep all control on the host country level, on the other hand, will
prevent access to scale advantages in small countries and will ultimately make
?nancial intermediation more expensive in small countries than in larger ones[7].
The main underlying argument in favour of more extensive jurisdictions in ?nancial
supervision is economies of scale in important banking activities[8]. Advances in
information processing and storage technology, which continuously reduce hardware
costs, shift the emphasis to software production in which development costs dominate.
At the same time, the on-going rapid reduction in communication costs reduce the
coordination costs that previously made extensive global operations expensive.
Due to these on-going trends the future of ?nancial intermediation will be characterized
by increasing scale advantages. In particular this is likely to hold in commercial
banking that serves customers who themselves run cross border businesses.
Obviously a supervisory authority with a mandate that is geographically much
more limited than the operations of the ?rms they supervise will have some dif?culties
in exercising its authority over the supervised units. Thus, there is a good case for
increasing the extension of the jurisdiction for the supervisory authorities to match the
growth in size of economically ef?cient ?rms in ?nancial services.
A counterargument against increasing the size of jurisdictions in ?nancial
supervision is that more extensive jurisdictions imply larger average distances
between the central supervisory authority and the ?nancial institutions that fall under
its mandate. A larger distance is likely to make monitoring more dif?cult and thus
increase the likelihood of a chain of events that will go undetected until it is too late to
prevent a disastrous outcome. However, potential advantages of geographic
proximity between supervisor and supervised should be handled by appropriate
decentralization of the monitoring activities, not by trying to preserve overly restricted
jurisdictions.
A more serious drawback, similar to the one that forms the basis for the argument
that Romano (2012) has advanced against harmonization of ?nancial regulation, is that
if there are fewer jurisdictions globally – which must be the case if they are larger –
there will be less of regulatory competition, and if there is less competition the risk that
the ?nancial sector gets stuck with obsolete regulation will increase.
The problem with this argument is that competition in ?nancial regulation is
unlikely to be very ef?cient from a social point of view in any case. A large number of
other factors than legal rules and regulations vary between countries belonging to
different jurisdictions and will thus have an impact on the outcome of the competition
between the countries. The enforcement of existing regulation will also most likely
vary from one country to another. Exactly the same rules may apply but if they are
strictly enforced in one jurisdiction but not in the other there will be a major difference
between the countries. Because of all other factors that make regions different, it will be
extremely dif?cult to judge weather one set of rules in ?nancial supervisions has
outperformed another set of rules, or vice-versa. Since an obvious ranking of the
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ef?ciency of existing supervisory regimes in different geographical areas is dif?cult to
establish, convergence towards better functioning supervisory mechanisms is bound
to take place very slowly, if at all.
3. Political economy aspects on banking supervision
In addition to technology driven scale advantages an endemic problem in ?nancial
supervision is what is commonly called regulatory capture[9]. This problemis important
in trying to establish the appropriate extension of the jurisdiction of supervisory
authorities. Regulatory capture is the phenomenon that regulators start to identify
themselves with the objects for the regulation. This can take blatant forms, like a
supervised unit trying to bribe off of?cials that are in charge of the supervisory activities,
but regulatory capture will also occur well within the limits provided by the law.
The reason why regulatory capture is so dif?cult to weed out completely from
?nancial supervision is that regulatory capture is closely related to requirements for
making monitoring of ?nancial institutions as ef?cient as possible. For monitoring to
be ef?cient those who are conducting it must have access to timely and accurate
information and a relatively deep understanding of the business. Since supervisory
authorities usually are less well informed than the persons they supervise, i.e. those
who are in charge of running the supervised activity, supervisors can improve their
access to information if they are on friendly terms with people close to the source of the
information, that is, if they are on friendly terms with those who run the business.
“being on friendly terms” again must build on some form of empathy that may be
misused by those who are subject to the monitoring activity.
In setting up appropriate regulation it is important to recognize the impossibility of
drawing a strict line between what is likely to result in harmful regulatory capture on
one hand, and what is desirable as a result of a smoother ?ow of relevant information
from supervised units to the supervisor on the other. Any attempts to draw such lines
by establishing strict rules will only result in expensive resources being wasted on
different ways to circumvent the rules. To make monitoring as ef?cient as possible the
persons that are in charge of the monitoring should instead be given the freedom to
behave in a non-predictable way every once in a while.
Due to regulators’ frequent need for high quality information regulatory capture will
remain a potential problem even in otherwise ef?cient jurisdictions. Some cases where
excessive regulatory capture is highly likely to become a major problem can easily be
identi?ed. These are cases where the regulators personal wealth will be dependent on
whether the regulated unit is allowed to continue with its operations or not. In those
cases there is an obvious danger that the regulator may end up in a situation where
“sounding the bell” on reckless risk-taking will be avoided at all cost: better to stay put
and hope for the best. Small jurisdictions will be more exposed to this danger than large
jurisdictions. In large jurisdictions the supervising authority has a larger number of
supervised business units to take care of. Thus, a forced liquidation of one of the units
will not eliminate the jobs for those who personally are in charge of the supervision of
that unit.
The simple principle that this leads to is that the jurisdiction in ?nancial supervision
should be extensive enough not to give rise to natural monopolies in any important
business area that the ?rms within the jurisdiction are involved in. Since natural
monopolies arise when average costs decrease beyond business volumes that cover
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the whole market, that is where scale economies exist even for the biggest ?rms in
the jurisdiction. This principle implies that the size of the jurisdiction should be
determined on the basis of minimumef?cient scales in the ?nancial services industry[10].
As discussed in Boyd and Heitz (2011) and Davies and Tracey (2012) the question of
scale economies in banking activities is likely to be more problematic than in other
areas. The reason is that the implicit subsidy produced by the TBTF phenomenon
will be a signi?cant part of the scale advantages for the largest banks[11]. However, for
conclusions concerning an optimally sized jurisdiction any scale advantages due
TBTF phenomenon will even more strongly call for large enough jurisdictions,
provided that the regulators can be con?dent that the immediate losses if a large
?nancial institution has to be closed down and resolved can properly be handled within
that jurisdiction[12].
To confer the supervisory authority on an institution with a large enough
jurisdiction will not be suf?cient to address the TBTF problem, though. Even if –
based on purely technical factors – there is scope for a relatively large number of
?nancial institutions operating at minimum ef?cient scale within the relevant
jurisdiction there must still be enough of disincentives for each ?nancial institution to
offset any TBTF funding advantages that an individual ?rm might be able to obtain by
increasing their scale far beyond what would be justi?ed from a purely technological
point of view. However, preventing individual players from becoming too dominant is
precisely the challenge that competition authorities are facing in other industries too.
4. Conclusions
This paper discusses factors that have an impact on the optimal size of the jurisdiction
of the supervisory authorities under which a ?nancial institution is operating.
The need to carefully tackle this issue stems from the fact that an ever-larger number
of ?nancial institutions have signi?cant operations abroad. Thus, supervision on a
national level will either fail to cover most of the ?nancial institution’s activities or the
multinational ?nancial institution will be subject to overlapping supervision from a
number of national supervisors.
To address this problem strict coordination between national supervisors is
required or a cross-border jurisdiction has to be introduced. In this paper the latter
alternative has been discussed.
The most important factor that calls for more extensive jurisdictions than the
present ones is economies of scale in many areas of banking business. As technology
develops, sophisticated software that deliver solutions even to relatively complicated
problems faced by customers, in a customer friendly way, will become ever more
common in the banking business. Since software costs are largely development costs
having access to a large customer base will become increasingly important. A large
customer base allows distribution of the largely ?xed, development costs on a large
number of individuals. Reduced communication costs are simultaneously reducing
the coordination costs that traditionally have been the main reason for observing
disadvantages to scale beyond certain sized organizations.
Since large organizations will have a cost advantage relative to small ones it will be
costly to try to prevent ?nancial institutions frombecoming large enough to fully exploit
that advantage. To safeguard that the supervisors who are in charge of monitoring these
big ?rms will not too easily become subject to regulatory capture the supervisory
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jurisdiction that these large ?rms operate in has to be extensive enough to encompass a
number of such large ?rms. A supervisory authority that has one or two really large
?nancial institutions to monitor will be too dependent on these institutions to be able to
act independently. Such an authority will not be able to credibly uphold the main threat
that makes ?nancial institutions comply with the regulation, that is the threat of closing
down the ?rm that has mismanaged its assets and liabilities.
Notes
1. See the report of the High-level Expert Group on Reforming the Structure of the EU Banking
Sector (2012).
2. See Buiter and Sibert (2008).
3. See in particular Barth and Prabha (2013) but also the general discussion in
Brunnermeier et al. (2009).
4. Including the need for experimentation, that is allowing different sets of rules to compete in
practice (Romano, 2012) to establish whether some of them are preferable to others.
5. An extensive survey of early studies can be found in Berger and Humphrey (1997). For a
knowledgeable discussion of advances and challenges in the research on scale economies in
banking, see Mester (2008).
6. Up to assets of $1.5 trillion in Feng and Serilitis (2009).
7. Keeping the control at the host country level implies that foreign banks have to operate as
independent subsidiaries whereas if the control is maintained on the home country level the
bank can simply set up branches in the foreign country. For a discussion of the different
aspects involved see Luciano and Wihlborg (2013).
8. A number of researchers, however, claim that the implicit subsidy from the “too big to fail”
phenomenon is the most important component in the advantages to scale in modern
banking. See Boyd and Heitz (2011).
9. See Stigler (1971). An interesting discussion of the need to split up ?nancial supervision
between different organizations to counteract regulatory capture can be found in Boyer and
Ponce (2012).
10. The above arguments imply that the optimal size of the jurisdiction will most likely grow
over time. Sophisticated software will become ever more important in ?nancial services
tilting the costs structure towards higher ?xed costs, and reducing the coordination costs
that tend to increase costs on the margin in any organisation.
11. Davies and Tracey (2012) conclude that in their sample of 172 large banks (assets above
50 billion USD), no signi?cant economies of scale when TBTF funding advantages are left
out. However, when the implicit subsidy from assumed TBTF status is taken into account
there are scale advantages for the banks in this sample.
12. Since the decision to close down a ?nancial institution must be taken quickly so as to avoid a
situation where the banks business partners start to “scramble for the exit” their must be a
sizeable enough “resolution fund” in the form of irrevocable commitments from the countries
that share the same supervisory jurisdiction.
References
Berger, A.N. and Humphrey, D.B. (1997), “Ef?ciency of ?nancial institutions: international
survey and directions for future research”, European Journal of Operational Research,
Vol. 98, pp. 175-212.
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Further reading
Haldane, A.G. (2010), “The $100 billion question”, comments given at the Institute of Regulation and
Risk, Hong Kong, available at: www.bankofengland.co.uk/publications/Documents/speeches/
2010/speech433.pdf
Corresponding author
Tom Patrik Berglund can be contacted at: berglund@hanken.?
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