Supervisory Shopping in the Banking Sector : When is it Socially Desirable?

This paper analyzes the welfare impact of supervisory shopping in the banking sector. Supervisory shopping leads to a welfare-increasing "race to the top" among supervisors, if strong supervision increases banks' access to deposits by signaling that banks have a less risky balance sheet. However, if deposits are subsidized through an underpriced financial safety net, banks shop for a weak supervisor in order to maximize gains from risk-shifting. Supervisory shopping then precipitates a "race to the bottom." In an extension of the framework, contingent convertible bonds (CoCos) prevent banks from risk-shifting and supervisory shopping becomes socially desirable again