1 Introduction
Besides the aim of protecting small depositors, controlling systemic risk is
cited as one of the main arguments for banking regulation and supervision.
Systemic risk is the probability that the failure of one single bank leads
to successive losses along the chain of institutions with negative impact on
the whole economy.1 The higher the interconnections within the banking
system, the higher are the subsequent losses after an individual bank failure.
As financial markets have increasingly become integrated across national
borders, these losses can partially incur outside the country where the bank
failure took place. This contagion effect is particularly relevant in Europe
where the highly integrated interbank market could function as a channel for
cross-border spillovers.
As banks are not liable to losses incurred by their bankruptcy, they do not
account for losses of their direct stakeholders nor the just described negative
effects further down the chain when deciding on their investment strategy.
In the absence of regulation, the probability of failure is, thus, assumed to
be inefficiently high. Hence, regulators employ their instruments in order
to increase social welfare. Among the regulatory tools, capital requirements
currently seem to be the most accepted instrument.2 In order to ensure com-
pliance with the imposed rules, supervisors monitor banks and take counter-
measure in case of deviation.
In the EU, it is the ”home country” which has full responsibility for
banking supervision of individual banks. This national approach means that
supervisors are accountable to their own jurisdiction and that their mandate
is to guarantee prudential behavior of home banks and to safeguard systemic
stability in their own country. Accordingly, incentives are such that supervi-
sors use their discretion to follow national interests. This institutional design
has two consequences for the national supervisors’ behavior. First, supervi-
sors will pay attention only to the repercussions the failure of a financial
institution has on the own economy. However, they will disregard the poten-
tial negative effects which are transmitted into other EU countries via the
highly integrated interbank market. Second, although supervisors would like
to take the risks into account which derive from the bank’s activity abroad,
they may lack information to do so as their foreign colleagues do not have
incentives to deliver the necessary data on the bank’s activities abroad.
1 There is no generally accepted definition of systemic risk (see Summer (2002) for a
survey). My definition comes closest to Kaufman ’s (1995) one (p. 47).
2 Capital requirements are seen as providing a ”buffer” in bad times and preventing
banks from risk-taking ex ante. See, for instance, Rochet (1992) and Dewatripont and
Tirole (1993).