Optimal bank regulation and fiscal capacity

Stavrakeva, V (2019) Optimal bank regulation and fiscal capacity. The Review of Economic Studies. ISSN 0034-6527 (In Press)

Abstract

Financial regulation is harmonized across countries even though countries vary in their ability to bail-out their banking sector in the event of a crisis. This paper addresses the question of whether countries with different fiscal capacity should optimally have different bank regulation, implemented — among other tools — through capital requirements — a question so far ignored by the theoretical banking literature. I show that countries with larger fiscal capacity should have lower ex-ante minimum bank capital requirements, in an environment with endogenously incomplete markets and overinvestment due to “Too-Big-To-Fail” moral hazard and pecuniary externalities. I also show that, in addition to a minimum bank capital requirement, regulators in countries with strong “Too-Big-To-Fail” moral hazard should impose a limit on the liabilities pledged by financial institutions in a crisis state. This implies limits on put options/CDS contracts. Finally, I argue that the type of regulatory instrument used is crucial as to whether larger fiscal capacity implies more or less stringent bank regulation.

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Item Type: Article
Subject Areas: Economics
Date Deposited: 12 Apr 2019 12:37
Last Modified: 07 Aug 2019 12:49
URI: http://lbsresearch.london.edu/id/eprint/1117
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