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 article addresses the question of whether countries with different fiscal capacity should optimally have different bank regulation, implemented—among other tools—through 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/credit default swap 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

We investigate the role that regulatory strictness plays on the enforcement of financial reporting transparency in the U.S. banking industry. Using a novel measure of regulatory strictness in the enforcement of capital adequacy, we show that strict regulators are more likely to enforce restatements of banks' call reports. Further, we find that the effect of regulatory strictness on accounting enforcement is strongest in periods leading up to economic downturns and for banks with riskier asset portfolios. Overall, the results from our study indicate that regulatory oversight plays an important role in enforcing financial reporting transparency, particularly in periods leading up to economic crises. We interpret this evidence as inconsistent with the idea that strict bank regulators put significant weight on concerns about the potential destabilizing effects of accounting transparency

We study a situation in which a regulator relies on risk models that banks produce in order to regulate them. A bank can generate more than one model and choose which models to reveal to the regulator. The regulator can find out the other models by monitoring the bank, but in equilibrium, monitoring induces the bank to produce less information. We show that a high level of monitoring is desirable when the bank’s private gain from producing more information is either sufficiently high or sufficiently low. When public models are more precise, banks produce more information, but the regulator may end up monitoring more

We show that borrowing firms benefit substantially from important enforcement actions issued on U.S. banks for safety and soundness reasons. Using hand-collected data on such actions from the main three U.S. regulators and syndicated loan deals over the years 1997–2014, we find that enforcement actions decrease the total cost of borrowing by approximately 22 basis points (or $4.6 million interest for the average loan). We attribute our finding to a competition-reputation effect that works over and above the lower risk of punished banks post-enforcement and survives in a number of sensitivity tests. We also find that this effect persists for approximately four years post-enforcement

We show how shareholder-debtholder agency conflicts interact with strategic reporting under asymmetric information to influence bank regulation. Relative to a benchmark unregulated economy, higher capital requirements mitigate inefficient asset substitution, but potentially exacerbate underinvestment due to debt overhang. The optimal regulatory policy balances distortions created by agency conflicts and asymmetric information while incorporating the social benefit of bank debt. Asymmetric information and strategic reporting only impact regulation for intermediate social debt benefit levels. For lower social debt benefits in this interval, regulatory capital requirements are insensitive to accounting reports, so bank balance sheets need not be marked to market to implement the optimal regulatory policy. For higher social debt benefits, however, capital requirements are sensitive to accounting reports, thereby necessitating mark-to-market accounting to implement bank regulation. Mark-to-market accounting is essential when bank leverage levels are high, and is more likely to be necessary as banks' asset risk or specificity increases

Recent literature suggests that higher capital requirements for banks might lead to a socially costly crowding out of deposits by equity. This paper shows that additional equity in banks can help to crowd in deposits. Intuitively, as banks have more equity and become safer, the cost of deposit funding may decline; this, in turn, can encourage banks to expand their deposits. However, I also find that, for this effect to occur, capital requirements may have to be stringent enough: When bank capital is low, a small rise in capital requirements can cause banks to substitute equity for deposits. Overall, a non-monotonic relationship between the required amount of equity in banks and their level of deposit funding obtains

We model how securities dealers respond to regulations on leverage, position, and liquidity such as those imposed by the Basel III framework. The dealers respond by endogenously moving to make markets on an agency basis, matching buyers to sellers rather than taking client positions on the balance sheet. Agency-based market making creates a cost-risk tradeoff in which investor welfare declines but dealers become less risky. The costs to investors do not show up in all liquidity metrics: While asset prices exhibit greater price impact, bid-ask spreads do not change and trading volumes can even increase, which can help explain the varying findings from the empirical literature

Commercial banks in China issued a multitude of wealth management products (WMPs) from 2009 to 2016. These products are largely short-term, but a significant proportion of capital is allocated to long-term investments. In this paper, we first construct a measure of WMP maturity mismatch for each bank in each quarter using R2s from regressing expected yields of WMPs on expected yields of banks’ generally claimed investment assets. The degree of maturity mismatch is positively related to banks’ quarter-end non-performing loan ratio (NPLR), after accounting for time-varying bank characteristics, bank and time fixed effects. The result indicates that severer mismatch is associated with reduced NPLR. Cross-sectionally, the positive relation is stronger in big banks and when banks had a larger NPLR in the previous quarter. The results highlight the fact that regulated commercial banks use financial innovation and exploit maturity mismatch in their issued WMPs to evade regulator's credit risk monitoring

We examine whether stress tests distort banks' risk‐taking decisions. We study a model in which a regulator may choose to rescue banks in the event of concurrent bank failures. Our analysis reveals a novel coordination role of stress tests. Disclosure of stress‐test results informs banks of the failure likelihood of other banks, which can reduce welfare by facilitating banks' coordination in risk‐taking. However, conducting stress tests also enables the regulator to more effectively intervene banks, coordinating them preemptively into taking lower risks. We find that, if the regulator has a strong incentive to bail out, stress tests improve welfare, whereas if the regulator's incentive to bail out is weak, stress tests impair welfare

We examine the cleansing effect of financial crises via their contribution to the exit of inefficient US commercial banks from 1984 to 2013. We find a larger increase in the exit likelihood of less efficient banks as compared to more efficient banks in the years of the Savings and Loans Crisis but not during the Global Financial Crisis. We highlight how the magnitude of the shock of the Global Financial Crisis and the subsequent, broad government interventions might explain these different results. Furthermore, we highlight that both crisis periods have a disproportionate effect on young banks regardless of their efficiency levels and that they do not generate any positive spillover effects on surviving banks in the three years post-crises in spite of some reallocation benefits in favor of new entry banks. Our findings highlight that forms of prudential regulation designed to strengthen bank resilience in good times might contribute to mitigating the effects of crisis on the longer-term productivity of the banking industry