Size Matters: Bank Capital Regulation With Asymmetric Countries

Abstract

Financial markets are increasingly globalized, so that the impacts of national banking regulations extend beyond national borders. Strict regulation reduces global loan supply and thus widens interest rate spreads. This is an externality insofar as it affects foreign banks’ profitability and stability. The sovereign’s motivation to join an internationally coordinated regulatory regime, such as the Basel Accords, has been discussed in the literature. However, regulatory enforcement remains a domestic responsibility. In combination with asymmetric information, this gives national authorities room to deviate in the form of lax regulation. We show that each regulator’s enforcement choice is affected by the relative country size. Lax enforcement improves the profitability of home banks, but diminishes the global interest rate spreads. An authority regulating a small market has only a small effect on global interest rates. As such, it may choose lax regulation to improve domestic bank profitability without significantly diminishing global spreads. In contrast, an authority regulating a large market will have a significant impact on global spreads. Therefore, small country regulators have a stronger incentive to deviate from strict international regulatory standards.