A regulatory arbitrage game: Off-balance-sheet leverage and financial fragility

Abstract

This study examines a simple banking system in a game-theoretic framework wherein banks act as self-interested agents to maximize leverage at the expense of overall financial stability. The resultant strategic inefficiency raises concerns about how banks manage the "financial stability" good, which is appropriated into a "tragedy of the commons." We conceptualize the inefficiency using the price of anarchy introduced by Koutsoupias & Papadimitriou (2009). We seek the optimal regulatory framework that minimizes the price of anarchy or the degree of financial fragility.