Jagdish Tripathy
Does macroprudential regulation spillover to foreign financial systems through inter-bank linkages? This question has received a lot of attention in recent years given the discord between the international nature of the global financial system and its regulation and supervision by national jurisdictions (e.g. this article). For example, subsidiaries of Spanish banks issue almost half of all credit issued by commercial banks in Mexico. These subsidiaries are also fully owned by their parent banks headquartered in Spain. Therefore, it is quite natural to ask whether macroprudential regulations in Spain can have unintended consequences on the Mexican financial system and the Mexican economy in general. While Mexican subsidiaries of Spanish banks are de-jure ring-fenced from regulations in Spain, does this hold de-facto?
I document an instance where a Spanish regulation in 2012, entirely unrelated to the Mexican financial system and aimed solely at Spanish exposures of banks resident in Spain, had unintended consequences on bank lending and economic activity in Mexico. This was a result of the Spanish regulation spilling over to Mexican shores through the link between parent banks headquartered in Spain and their subsidiaries in Mexico.
1. Regulatory spillovers – action at a distance
Domestic financial regulations can spillover to foreign jurisdictions through interconnections between globalized banks. To develop intuition for a spillover of regulations across national borders, let us look at channels through which financial regulations in country A, for instance, may spillover to the financial system of country B.
Figure 1 pictorially depicts some candidate channels. Regulations in country A may spillover to country B through (1) financial links between domestic banks of country A and their foreign subsidiaries ( I ↔ I* ), (2) those between foreign subsidiaries in country A with their parent institutions in country B ( II* ↔ II ) and (3) inter-bank lending between banks in A and B ( I ↔ II ). This post focuses on an instance of spillovers of type (1) – where the impact of a domestic regulation in country A (Spain) affected the banking operations of subsidiaries of country A in country B (Mexico).
Figure 1: International spillover of banking regulation (Country A → Country B)
2. Case study of a trans-Atlantic spillover
In February and May 2012, the newly elected Spanish Government imposed loan-loss provisions on Spanish real estate assets in the balance sheets of Spanish banks. The provisions were imposed on the outstanding assets as of December 2011 and were meant to address market concerns regarding the ability of Spanish banks to cover losses from toxic Spanish real estate assets (for more details see Banco de España’s November 2012 Financial Stability Report). Therefore, this regulation was entirely unrelated to credit conditions in Mexico.
These measures imposed capital requirements in the order of billions of euros on the large Spanish banking groups such as BBVA and Santander. These banks have a significant presence in Mexico through two fully-owned subsidiaries, accounting for almost half of all mortgages and more than a third of corporate credit issued by commercial banks in Mexico. The Spanish regulation impacted the Mexican financial system through the link between these subsidiaries and their parent banks in Spain.
Figure 2 shows a sharp contraction in the growth rate of lending to Mexican households by Spanish banks in Mexico (blue-dashed line) in the immediate aftermath of the regulations in Spain. This contraction in lending in the form of mortgages and consumer credit (mostly credit cards) came at a time when the competitors of Spanish banks (red-dotted line) seemed to be doing the opposite.
This contraction is striking because the Mexican subsidiaries of Spanish banks adhere to Mexican regulations; any change in capital or provision requirements in a foreign financial system, such as the one in Spain, does not apply to their lending operations in Mexico. That said, the Mexican subsidiaries of Spanish banks are fully owned by their parent banks in Spain and may be susceptible to shocks to the funding position of the latter.
A second striking feature of the contraction is that the Spanish banks cut back lending in a relatively profitable market (as reported in their 2012 annual reports, e.g. BBVA’s) when faced with a capital crunch. The factor that helps account for this is the elevated cost of capital during the global financial crisis – Spanish banks would have found it difficult to substitute the capital set aside to meet the regulations by raising additional equity. Hence covering any capital shortfalls by investing in Mexico would not have been an option.
Figure 2: Growth in credit lending by Spanish and non-Spanish banks in Mexico
Note: This figure plots growth rates of credit issued by Spanish and non-Spanish banks in Mexico during December 2010 to December 2013. The growth rate is calculated against the level a year ago for the corresponding credit type.
Based on results reported in my paper, I estimate that the contraction in lending accounts for ~600 million USD worth of mortgages and consumer loans not being extended to Mexican households in the year following the announcement of the Spanish regulations.
This contraction in household credit was concentrated in Mexican municipalities highly exposed to the subsidiaries of Spanish banks. In fact, the share of these subsidiaries in a given municipality was a strong predictor of the decline in lending to households in the immediate aftermath of the regulation – the higher the share, the larger the contraction in household credit. Figure 3 shows the geographical distribution of these high-exposure municipalities which experienced localised contractions in household credit by Spanish banks. In fact, these municipalities experienced an aggregate contraction in lending to households since non-Spanish banks did not offset the drop in lending by Spanish banks.
Figure 3: Share of Spanish banks in the household credit market across Mexican municipalities
Note: The figure shows the exposure of Mexican municipalities to Spanish banks. Exposure is defined based on the proportion of household credit issued by Spanish banks in the municipality. High exposure municipalities experienced larger contractions in lending to households as a result of the Spanish regulation.
Can such localised contractions in lending to households have knock-on effects on the macroeconomy of Mexican municipalities? A drop in access to household credit affects the ability of households to refinance their debts and to smooth consumption. Research has shown that households reliant on credit for consumption have particularly high marginal propensity to consume (e.g. this paper).
Thus a contraction in household credit often leads to a drop in aggregate demand for goods and services. In turn, a localised drop in aggregate demand affects economic activity in firms that specifically cater to local demand, such as firms in retail and related industries which belong to the local non-tradable sector.
I find that the Mexican municipalities which underwent a contraction in lending to households also experienced a contraction in the local non-tradable sector. The tradable sector resident in these municipalities remained unaffected by the contraction in lending to households.
Thus the subsidiaries of Spanish banks acted as a conduit for the Spanish macroprudential regulations spilling over to the Mexican financial system – accounting for both the drop in lending to Mexican households and the ensuing drop in economic activity in the non-tradable sector of Mexican municipalities exposed to the first effect.
A singular feature of the spillover to Mexico is that it was concentrated in lending to households. I find that neither cancelled loans nor newly issued loans to Mexican firms in the immediate aftermath of the regulation were more likely to be issued by the subsidiaries of Spanish banks. This lack of spillover to firms suggests the potential for asymmetric effects of macroprudential regulations on different sectors of banks’ lending portfolio.
One possible reason for the asymmetric effect is the higher capital requirements for some cross-sections of mortgage lending in Mexico as reported by the Bank for International Settlements. Another potential source for asymmetric effects is the relationship distance between banks and borrower-types. Faced with the need to cut lending, banks are likely to prioritise loans to borrowers from whom they can extract valuable relationship/incumbency rents.
3. Regulatory spillovers and the UK
What are the implications of the above findings for a highly open financial system such as that of the UK? International branches and subsidiaries of foreign-owned banks operating in the UK account for a significant share of domestic lending (credit) in the UK. These international banks accounted for a quarter of the stock of lending to firms at end-2016 and more than half of the new loans issued to firms in 2016. The share of foreign banks in the household credit market is lower (13% and 6% in stock and flow respectively).
These large shares underscore the importance of monitoring foreign macroprudential regulations that can affect lending by international banks operating in the UK. Nor should we take our eyes off foreign regulations that may affect domestic UK banks, many of which have large international interests of their own.
Table 1: Share of international banks in domestic lending in the UK
Sub-Table a: Stock of credit at end-2016
| Households | Firms | Households + Firms | |
| Domestics Banks | 87% | 76% | 84% |
| International Branches | 1% | 18% | 5% |
| International Subsidiaries | 12% | 6% | 11% |
| Total | 100% | 100% | 100% |
Sub-Table b: Flow of credit in 2016
| Households | Firms | Households + Firms | |
| Domestics Banks | 94% | 49% | 86% |
| International Branches | 3% | 45% | 10% |
| International Subsidiaries | 3% | 6% | 4% |
| Total | 100% | 100% | 100% |
Jagdish Tripathy works in the Bank’s Financial Stability Strategy and Risk Division.
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