Regulatory arbitrage and economic stability

This paper shows that national bank regulation can ensure financial and economy stability only if business cycles are driven by domestic and non-financial global shocks. If global financial shocks are more important, by contrast, national regulatory policies can be destabilizing. These inferences are drawn from a two-country DSGE model with global banking, financial regulation and the financial accelerator mechanism. The results indicate that bank regulation suppresses the amplification effects of the financial accelerator mechanism when countries face domestic and non-financial global shocks. When there is a global financial shock, however, highly-regulated countries are more vulnerable to the ebbs and flows of global bank lending since their firms are more leveraged and externally funded. More generally, the results imply that the financial trilemma is not binding in economies where domestic and non-financial global shocks drive the business cycle.