Is there a bright side to regulatory arbitrage?

Regulatory arbitrage has a negative connotation, even though it is not necessarily illegal. It can be defined as “a corporate practice of utilising more favourable laws in one jurisdiction to circumvent less favourable regulations elsewhere.” In the financial sector, banks might shift assets and risks between countries due to differences in regulatory regimes. In a recently published paper, Consuelo Silva-Buston, Wolf Wagner and I show that cross-border supervisory cooperation agreements can also result in regulatory arbitrage with risks being shifted to third countries. With supervisory scrutiny increasing and supervisors becoming more willing to intervene in cross-border banks early as they cooperate with supervisors in other countries, global banks have incentives to shift risks to third countries not affected by cooperation agreements.

However, is there also a bright side to regulatory arbitrage? Might shifting lending and risks to third countries benefit borrowers in these jurisdictions? On the one hand, countries with weaker regulatory standards may receive capital inflows that allow firms to borrow more, potentially alleviating financial constraints  On the other hand, such benefits would be conditional on whether the additional lending is targeted at well-managed, efficient and profitable firms, as purely risk-motivated reallocation might result in negative net present value (NPV) projects being funded.

In a new working paper, we consider these different hypotheses and use the syndicated loan market as a laboratory to explore the effects of regulatory arbitrage on lending terms and firm behaviour and performance.

We first show that a subsidiary of a bank group extends larger loans to firms when the extent to which the cooperation covers the group’s global operations (excluding the subsidiary country itself) increases (for example, as a result of the parent country of the group forming a cooperation agreement with another country in which the group has subsidiaries). We also consider the effect on loan pricing and find that when cooperation elsewhere increases the subsidiary also offers lower lending rates to firms.

However, is this additional lending at lower rates risky? We next investigate which types of firms benefit from this improvement in lending conditions. Our results suggest that the firms that benefit most from improved lending conditions are high-quality firms that are less likely to fail and firms with which the bank is less at an information disadvantage (in our case because they have an existing relationship with the firm).

Finally, we consider whether there are real benefits arising from a shift in lending conditions. We show that firms that borrow from banks that receive positive shocks from third-country supervisory cooperation expand their activities. Specifically, they increase their asset bases, have higher capital expenditures and do more R&D. These firms also see their profits increase. This is consistent with financing constraints being eased in such firms with higher and cheaper lending.

Overall, this points to positive real effects arising from regulatory arbitrage. In particular, the fact that the additional lending seems to be targeted at high-quality safe firms coupled with the fact that financial constraints are likely to be tighter in countries with weaker supervisory standards (and hence those receiving the inflows) allows the possibility that a reallocation of lending between countries overall alleviates financial constraints. So, clearly there is a bright side to regulatory arbitrage!

This is by no means a claim that regulatory arbitrage overall is desirable. Instead, our results suggest that there are likely to be trade-offs between additional lending and financial stability.