Working Paper: NBER ID: w8669
Authors: Hanswerner Sinn
Abstract: Limited liability and asymmetric information between an investment bank and its lenders provide an incentive for a bank to undercapitalise and finance overly risky business projects. To counter this market failure, national governments have imposed solvency constraints on banks. However, these constraints may not survive in systems competition, as systems competition is likely to suffer from the same type of information asymmetry which induced the private market failure and which brought in the government in the first place (Selection Principle). As national solvency regulation creates a positive international policy externality on foreign lenders of domestic banks, there will be an undersupply of such regulation. This may explain why Asian banks were undercapitalised and took excessive risks before the banking crisis emerged.
Keywords: banking risks; limited liability; asymmetric information; solvency constraints; regulatory competition
JEL Codes: D8; H0
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Limited liability (K13) | undercapitalization of banks (F65) |
| undercapitalization of banks (F65) | risk-taking behavior of banks (G21) |
| Limited liability (K13) | risk-taking behavior of banks (G21) |
| Regulatory environment (G38) | stability of banking systems (F65) |
| Weaker regulations (G18) | increased risk-taking (G41) |
| increased risk-taking (G41) | banking crises (G01) |
| banking failures (F65) | Basel Accords (G18) |