Optimal Bank Regulation and Fiscal Capacity

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Financial regulation is synchronized across countries despite the fact that countries vary widely in their ability to bail out their banking sector in the event of a …nancial crisis. This paper addresses the question of whether countries with dierent …scal capacity should optimally have dierent ex-ante minimum bank capital requirements. In an environment with endogenously in- complete markets and overinvestment because of moral hazard and pecuniary externalities, I show that countries with larger …scal capacity should have lower ex-ante minimum bank capital require- ments. This result is the opposite of what one may expect given that countries with larger …scal capacity often have stronger moral hazard. I also show that, in addition to a minimum bank capital requirement, regulators in countries with strong moral hazard (which are countries with a concen- trated …nancial sector and large …scal capacity) should impose a limit on the amount of liquidity pledged by …nancial institutions in a crisis state. This would entail restricting the amount of put options/CDS contracts sold by …nancial institutions, among other measures.