Optimal Bank Regulation and Fiscal Capacity

Abstract

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.