May 23, 2019

ECB published a working paper that analyzes the cross-border propagation of prudential regulation in the euro area. The study measures cross-border externalities of prudential regulation using the euro-area bank-level data. The data showed that domestic banks reduce lending after the tightening of capital requirements in other countries, while they increase lending when loan-to-value (LTV) limits or reserve requirements are tightened abroad. Additionally, foreign affiliates increase lending following the tightening of sector-specific capital buffers in the countries where their parent banks reside, with bank size and liquidity playing a role in determining the magnitude of cross-border spillovers.

The study used a panel of 248 euro area banks and found evidence for inward cross-border spillovers from capital regulation (capital requirements and sector-specific capital buffers), liquidity measures (reserve requirements), and borrower-based measures (LTV limits), along the two channels of transmission. For the first channel, via changes of lending by domestic banks in reaction to changes in the prudential policy abroad, it was found that euro-area domestic banks reduce, on average, lending following the exposure-weighted tightening of capital requirements in foreign EU countries. The paper also reveals that domestic banks increase their lending when facing tightened LTV limits or reserve requirements abroad. For the second channel, which operates via changes in lending of foreign affiliates, it was found that foreign subsidiaries and branches increase lending when sector-specific capital buffers, LTV limits, and local reserve requirements are tightened in the home countries where their parents reside.

These findings speak for leakages from these instruments, which operates via foreign affiliates. Taken together, these findings suggest that the sign of cross-border spillovers, that is, whether the tightening of the instrument abroad/in the home country leads to an increase or decrease in bank lending is instrument-specific. It appears that instruments directed toward specific borrowers/sectors, such as LTV limits or sector-specific capital buffers, or acting locally, such as reserve requirements, are prone to negative cross-border spillovers, while tightening of tools which act at the consolidated level, such as capital requirements, exerts positive spillovers—that is, it leads to a decrease in lending also abroad. It is also found that bank characteristics play a role in the propagation of cross-border spillovers for the first channel. In particular, the paper notes that euro-area domestic banks that are less liquid reduce their lending more when the exposure-weighted capital requirements are tightened. Tighter LTV limits abroad are likely to lead larger euro-area banks (as measured by total assets) to increase lending more than other banks.

 

Related Link: Working Paper (PDF)

 

Keywords: Europe, EU, Banking, Systemic Risk, Capital Requirements, LTV, Capital Buffers, Cross-Border Spillovers, Research, ECB

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