Optimal Bank Regulation and Fiscal Capacity

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 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.

Keywords: Optimal Bank Regulation, Derivative Regulation, Fiscal Capacity, Moral Hazard, Pecuniary Externalities

JEL Classification: G1, G2, E6