Political Economy of Banking Regulation

The paper argues that national regulators can improve the stability of the domestic banking sector via two substitutable policy instruments; minimum capital requirements and effort spend on domestic supervision. Both tools increase the soundness of a national banking system, but they imply different cost burdens between domestic banks and taxpayers. The optimal domestic policy choice is characterised by trading off marginal costs and benefits born by each party. However, the optimal policy choice changes if banks are allowed to be mobile. We show that countries are better off by harmonising capital requirements on an international standard la Basel, since harmonisation counters a regulatory race with other jurisdictions and will increase national utility.