Is the International Convergence of Capital Adequacy Regulation Desirable?

Abstract

I analyze the joint design of two bank regulatory mechanisms: minimum capital requirements, which are an ex-ante mechanism to prevent bank failures, and closure policy, which is an ex-post mechanism to manage the cost of bank failures. At the heart of the paper is a simple but fundamental point: ex-post policies affect ex-ante incentives, and hence the design of an ex-ante mechanism must take into account any feedback from the ex-post policies. The optimal design of capital requirements is thus tied to the extent of forbearance exercised by the central bank's closure policy. This warrants a closer scrutiny of the merits of creating a "level playing field" in capital requirements across countries. Linking the central bank's forbearance to its alignment with domestic bank owners, I show that such cross-border standardization is, in general, desirable only if accompanied by standardization of closure policies as well. When banks operate across borders, the lack of a complementary variation between capital requirements and regulatory forbearance gives rise to international spillovers from more forbearing to less forbearing regimes. Banks in more forbearing regimes undertake greater risk, which reduces the competitive advantage of banks in less forbearing regimes. Since these latter banks might be forced to exit the banking system, their central banks also adopt greater forbearance. As a result, all central banks converge towards the worst level of forbearance. Such regression is more likely the greater is the difference in the regulatory capture of central banks of different regimes. The resulting moral hazard has the potential to destabilize the global banking system compared to the situation in which there is no convergence of regulatory mechanisms.