Bank Capital Regulation with Asymmetric Countries

Financial markets are increasingly globalized, so that the impacts of na- tional 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 sovereigns' motivation to join an internationally coordinated regulatory regime, such as the Basel Accords, has been discussed in the literature. How- ever, regulatory enforcement remains a domestic responsibility. In combina- tion with asymmetric information, this gives national authorities room to deviate in the form of lax regulation. We show that each regulator's en- forcement 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 im- pact on global spreads. Therefore, small country regulators have a stronger incentive to deviate from strict international regulatory standards.