Working Paper: CEPR ID: DP5247
Authors: Alan Morrison; Lucy White
Abstract: We model the interaction between two economies where banks exhibit both adverse selection and moral hazard and bank regulators try to resolve these problems. We find that liberalizing bank capital flows between economies reduces total welfare by reducing the average size and efficiency of the banking sector. This effect can be countered by a adopting a 'level playing field' forcing international harmonization of capital requirements and deposit rates across economies. Such a policy is good for weaker regulators whereas a laissez-faire policy under which each country chooses its own capital requirement is better for the higher quality regulator. We find that imposing a level playing field among countries is globally optimal provided regulators? abilities are not too different, and comment on how shocks will be transmitted differently across the two policy regimes. We extend the model to allow for multinational banks, licensed by both regulators, showing that the same considerations arise in this context. Allowing multinationals improves welfare when bank capital can flow across borders, despite the negative impact on local banks.
Keywords: bank regulation; capital; international financial regulation; level playing field; multinational banks
JEL Codes: F36; G21; G28
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Liberalizing bank capital flows (F65) | Reduction in total welfare (D69) |
| Reduction in total welfare (D69) | Decrease in average size and efficiency of the banking sector (F65) |
| Level playing field (D43) | Counteracts negative effect of liberalizing bank capital flows (F65) |
| Laissez-faire approach (P10) | Favors stronger regulators (G18) |
| Imposition of a level playing field (Z28) | Globally optimal when regulators' abilities are not too disparate (D69) |
| Allowing multinational banks (F65) | Improve welfare when capital flows freely across borders (O24) |
| Regulatory coordination (L59) | Alleviate adverse welfare effects caused by unregulated capital flows (F32) |