DP16978 "Cooperation externalities": Supranational supervision and regulatory arbitrage
Banking supervisors frequently cooperate across countries, but cooperation only imperfectly covers the global operations of large banking groups. We show that this causes significant third-country externalities. Using hand-collected supervisory cooperation data, we document that banking groups shift lending activities and risk into third-country subsidiaries when cooperation agreements cover their operations in other countries. The implied country-level increase in the share of foreign loans is 16%. We also show that countries do not internalize third-country effects when making cooperation decisions, resulting in a 26 percentage point higher propensity to cooperate. Overall, our results highlight a need for "cooperating on cooperation."