We study the efficiency of banking regulation under financial integration. Banks freely choose the jurisdiction where to locate their activities and have private information about their efficiency level. Regulators non-cooperatively offer any regulatory contract that satisfies information and participation constraints of banks. We show that the unique Nash equilibrium of the regulatory game is a simple pooling contract: financial integration is characterized by the inability for regulators to discriminate between banks with different efficiency levels. This result is driven by the endogenous restriction caused by regulatory arbitrage on the capacity of regulators to use several regulatory instruments

We examine the optimal design of and interaction between capital and liquidity regulations. Banks, not internalizing fire sale externalities, overinvest in risky assets and underinvest in liquid assets in the competitive equilibrium. Capital requirements can alleviate the inefficiency, but banks respond by decreasing their liquidity ratios. When capital requirements are the only available tool, the regulator tightens them to offset banks’ lower liquidity ratios, leading to fewer risky assets and less liquidity compared with the second best. Macroprudential liquidity requirements that complement capital regulations implement the second best, improve financial stability, and allow for more investment in risky assets

We present a general equilibrium model of banks’ optimal capital structure where bankruptcy is costly and investors have heterogeneous endowments and incur a cost for participating in equity markets. We show that, besides its social benefits, capital regulation benefits bank shareholders when it resolves fire sales externalities but not when it acts as a tax on bank profits such as when used to control excessive leverage induced by deposit insurance. Furthermore, capital regulation widens the gap between the returns to bank shareholders and depositors and may reduce investments in projects in favor of storage

Using a sample of 27 countries between 1990 and 2014, we find that banks charge higher interest rates and adjust other contractual features of their loans when lending to firms facing more stringent environmental regulations. Our evidence suggests that lenders’ concerns about the increase in environmental liabilities resulting from regulations is driving the results. Specifically, we show that firms facing such regulations have fewer participants in their loan syndicates, higher bankruptcy risk, and lower credit ratings, despite reducing their leverage. Overall, our results indicate that the observed higher loan spread is the result of environmentally sensitive lending practices by banks

This paper reconsiders the risk-shifting problem of banks and presents a novel rationale for macroprudential regulation. The interplay between this agency problem and equilibrium investment creates a welfare-reducing pecuniary externality that causes capital misallocation and excessive bank risk taking. Therefore, the banking sector tends to be too large, under-capitalized, and inefficiently risky. This distortion is independent of typical frictions like government guarantees or default costs. Macroprudential regulation with capital requirements or deposit rate ceilings corrects misallocation thereby magnifying rent opportunities for banks to reduce risk shifting. Regulation is, however, no Pareto improvement and causes redistribution from households to bank owners

The tax benefit of interest deductibility encourages debt financing, but regulatory constraints create dependency between bank leverage and asset risk. Using a large international sample of banks this paper shows that banks located in high-tax countries have higher leverage and lower average asset risk-weights. This trade-off is stronger when regulation is more stringent and for banks with less capital. Non-financial firms' leverage and asset risk are positively related to tax rates, as further evidence of the regulatorily induced adjustment of portfolio risk. A difference-in-difference analysis provides support for a causal interpretation of these results. Overall, higher tax rates are positively correlated with systemic risk, suggesting that the lower asset risk does not offset the risk-inducing effect of tax rates on bank leverage

Government support to banks through the provision of explicit or implicit guarantees affects the willingness of banks to take on risk by reducing market discipline or by increasing charter value. We use an international sample of rated banks and find that government support is associated with more risk taking by banks. More importantly, we find that restricting banks’ range of activities ameliorates the link between government support and bank risk taking. We conclude that, in the presence of moral hazard induced by government support, reducing bank complexity strengthens market discipline

This study investigates if market risk-based capital requirements (MRR) implemented in 1998 mitigated bank risk associated with trading activities. Recognizing that only banks with sufficiently high trading activities are subject to the MRR (regulated), we implement a difference-in-difference (DID) approach to show that in the post-MRR period, unregulated banks experienced an increase in risk associated with trading activity, while their regulated counterparts enjoyed no appreciable change in trading-related risk. We interpret the resulting negative DID coefficient as the evidence of a risk-mitigating effect of the MRR. This effect disappears at already well-capitalized banks. We also show that upon the implementation of the MRR, unregulated banks exhibit a significantly larger increase in contribution of opaque trading activity to bid-ask spreads, compared to regulated banks, for which the association between trading activity and bid-ask spreads actually declines. Our results are consistent with the view that the MRR significantly reduced moral hazard and adverse selection problems associated with opaque trading activities

We investigate whether and how the uniqueness of banking activities affects the performance and systemic risk of U.S. banks. We find that banks performing more unique activities exhibit higher profitability and lower risk, controlling for size, diversification, and other key characteristics. We further find that banks’ sensitivity to systemic risk displays an inversely U-shaped relation with activity uniqueness. We interpret the impact of uniqueness in analogy to recent theories showing that systemic diversity promotes financial stability. Our study highlights the role of uniqueness in banking and has important implications for policy makers and banking regulators

In a two-country general equilibrium setting, we study competition between governments with two policy tools: capital requirements and a bank tax. Since banks raise equity and deposits from domestic and foreign households, governments face cross-country externalities the sign of which depends on the extent of positive spillovers, i.e., revenues from taxing banks, and negative spillovers, i.e., deposit guarantee costs. We show that regulatory competition yields the efficient allocation when governments have at their disposal policy tools that enable them to optimally internalize domestic distortions. Our first finding is that this is the case when governments are not restricted by supranational regulation. Our second finding is that supranational regulation may or may not impede efficiency. This conclusion is the result of a detailed analysis where we consider conceivable supranational regulatory schemes, derive their welfare implications and identify those that cause inefficiencies