DP5247 | Level Playing Fields in International Financial Regulation

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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.