Regulatory Arbitrage And Cross-Border Bank Acquisitions by SSRN

George Andrew Karolyi

Cornell University – Johnson Graduate School of Management

Alvaro G. Taboada

University of Tennessee

May 2, 2014

Journal of Finance, Forthcoming


We study how differences in bank regulation influence cross-border bank acquisition flows and the share price reactions to cross-border deal announcements. Using a sample of 7,297 domestic and 916 majority cross-border deals announced between 1995 and 2012, we find evidence of a form of “regulatory arbitrage” in which acquisition flows involve acquirers from countries with stronger regulations than their targets. Target and aggregate abnormal returns around deal announcements are positive and larger when acquirers come from more restrictive bank regulatory environments. We interpret this evidence as more consistent with a benign form of regulatory arbitrage than a potentially destructive one.

Regulatory Arbitrage And Cross-Border Bank Acquisitions – Introduction

The recent global financial crisis, caused in part by systemic failures in bank regulation (Levine (2012)), has sparked major overhauls in financial regulation throughout the world that include, among others, a strong push for stricter capital requirements and for greater international coordination in regulation. Consider, for example, that seven of the ten recommendations of 2011 Report of the Cross-Border Bank Resolution Group of the Basel Committee for Banking Supervision (BCBS) proposed greater coordination of national resolution measures to deal with the increasingly important cross-border activities of banks. The cost of centralizing bank regulation, of course, is that it limits flexibility in the design of policy toward greater crosscountry regulatory competition to the extent that a fully-harmonized global regulation would impose uniform standards across all countries (Acharya (2003)); Dell’Ariccia and Marquez (2006)). A benefit is that it internalizes any interdependencies that may exist across countries due to the integration of their financial systems. Indeed, a major push for stricter regulations has been a concern about one such interdependency; namely, an increase in the risk of “regulatory arbitrage.”

There are two views on the consequences of regulatory arbitrage in which banks from countries with stricter regulations engage in cross-border activities in countries with fewer regulations. On the one hand, banks engaging in such activities can maximize value for shareholders and improve capital allocation if regulatory arbitrage occurs when banks are constrained from pursuing profitable investment opportunities because of costly regulations in their home country. The benefits may not just accrue to the acquirer. Target banks may also benefit from “bonding” to a more robust regulatory regime after being acquired by banks from countries with stronger supervision. On the other hand, banks may engage in regulatory arbitrage to pursue value destroying activities in the form of excessive risk-taking, for example, by acquiring targets in countries with lax regulations and weak supervisors. This form of regulatory arbitrage could have adverse consequences on bank performance and shareholder value, for the parties to the deal and for the banking system as a whole, and could even be a catalyst for a harmful “race to the bottom” in bank regulations. Regulatory arbitrage of this harmful form can be especially dangerous as it increases the fragility of interconnected financial systems around the world if the acquiring banks can extract subsidies from the host country’s regulator, central bank or its taxpayers for losses from its more weakly-monitored risk exposures.

Understanding which banks engage in cross-border acquisitions and how stakeholders react to their announcement can thus be important toward understanding the motives for pursuing regulatory arbitrage.

In this paper, we examine whether regulatory arbitrage is taking place by means of one of the most important investing decisions that banks can engage in – a cross-border acquisition. Cross-border deals are a particularly useful setting to evaluate the effects of regulatory restrictions not only because the acquiring banks can, in effect, escape from some of the tough regulatory restrictions in their home country by acquiring institutions in weaker regimes but also because of the enormous growth in bank consolidation – domestic and especially cross-border – facilitated in part by major regulatory changes around the world. We furnish power to our tests by controlling for other motives for bank acquisitions, such as improvements in efficiency, increases in market power, as well as governance related motives, and by benchmarking against purely domestic deals. Ours is, to the best of our knowledge, the first study to examine regulatory arbitrage in cross-border bank acquisitions on a global basis.

Using a sample of 7,297 domestic and 916 majority cross-border deals cumulatively valued in excess of $2.8 trillion involving acquirers and targets from 78 countries over the period from 1995 through 2012, we first evaluate how differences in regulations influence the overall volume of cross-border bank acquisitions and the flow of deal activity between home countries of the bank acquirers and targets to determine whether the flows are in line with regulatory arbitrage. We next examine the impact on shareholder wealth created through the short-run stock price reactions of the acquirer and target bank to deal announcements. Finally, we examine how changes in merger control policy influence cross-border bank acquisition activity and how they may distort the potential impact of differences in bank regulations on those flows.

Bank Acquisitions

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