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DP4148 | Multinational Bank Regulation with Deposit Insurance and Diversification Effects

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We analyse a model in which bank deposits are insured and there is an exogenous cost of bank capital. The former effect results in bank over-investment and the latter in under-investment. Regulatory capital requirements introduce investment distortions, which are a constrained optimal response to these market imperfections. We show that capital requirements which are constrained optimal for national banks result in under-investment by multinational banks. The extent of under-investment depends upon the home bank?s riskiness, the extent of international diversification, and the liability structure (branch or subsidiary) of the multinational. Capital requirements for international banks should therefore reflect these effects. We relate our findings to observed features of multinational banks and we discuss the possible existence of a multinational bank channel for financial contagion.