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Risk Taking, Limited Liability and the Competition of Bank Regulators

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  • Hans-Werner Sinn

Abstract

Limited liability and asymmetric information between an investment bank and its lenders provide an incentive for a bank to undercapitalise and finance overly risky business projects. To counter this market failure, national governments have imposed solvency constraints on banks. However, these constraints may not survive in systems competition, as systems competition is likely to suffer from the same type of information asymmetry which induced the private market failure and which brought in the government in the first place (Selection Principle). As national solvency regulation creates a positive international policy externality on foreign lenders of domestic banks, there will be an undersupply of such regulation. This may explain why Asian banks were undercapitalised and took excessive risks before the banking crisis emerged.

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Bibliographic Info

Paper provided by CESifo Group Munich in its series CESifo Working Paper Series with number 603.

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Date of creation: 2001
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Handle: RePEc:ces:ceswps:_603

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Keywords: systems competition; Basel II; banking with limited liability and Lemon bonds;

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References

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  1. Christian Gollier & Pierre-François Koehl & Jean-Charles Rochet, 1996. "Risk-Taking Behavior with Limited Liability and Risk Aversion," Center for Financial Institutions Working Papers 96-13, Wharton School Center for Financial Institutions, University of Pennsylvania.
  2. Sheila C Dow, 1995. "Why the Banking System Should be Regulated," Working Papers Series 95/15, University of Stirling, Division of Economics.
  3. Sinn, Hans-Werner, 1986. "Risiko als Produktionsfaktor," Munich Reprints in Economics 19879, University of Munich, Department of Economics.
  4. Rudi Dornbusch, 2002. "The New International Architecture," CESifo Working Paper Series 769, CESifo Group Munich.
  5. Bester,Helmut Hellwig,Martin, 1987. "Moral hazard and equilibrium credit rationing: An overview of the issues," Discussion Paper Serie A 125, University of Bonn, Germany.
  6. Sinn, Hans-Werner, 1982. "Kinked utility and the demand for human wealth and liability insurance," European Economic Review, Elsevier, vol. 17(2), pages 149-162.
  7. Blum, Jurg & Hellwig, Martin, 1995. "The macroeconomic implications of capital adequacy requirements for banks," European Economic Review, Elsevier, vol. 39(3-4), pages 739-749, April.
  8. Hyman P. Minsky, 1992. "The Financial Instability Hypothesis," Economics Working Paper Archive wp_74, Levy Economics Institute.
  9. Sinn, Hans-Werner, 1997. "The selection principle and market failure in systems competition," Munich Reprints in Economics 19854, University of Munich, Department of Economics.
  10. Kydland, Finn E & Prescott, Edward C, 1977. "Rules Rather Than Discretion: The Inconsistency of Optimal Plans," Journal of Political Economy, University of Chicago Press, vol. 85(3), pages 473-91, June.
  11. Stiglitz, Joseph E & Weiss, Andrew, 1981. "Credit Rationing in Markets with Imperfect Information," American Economic Review, American Economic Association, vol. 71(3), pages 393-410, June.
  12. Giancarlo Corsetti & Paolo Pesenti & Nouriel Roubini, 1998. "What Caused the Asian Currency and Financial Crisis? Part II: The Policy Debate," NBER Working Papers 6834, National Bureau of Economic Research, Inc.
  13. Rochet, Jean-Charles, 1992. "Capital requirements and the behaviour of commercial banks," European Economic Review, Elsevier, vol. 36(5), pages 1137-1170, June.
  14. Kane, Edward J., 2000. "Capital movements, banking insolvency, and silent runs in the Asian financial crisis," Pacific-Basin Finance Journal, Elsevier, vol. 8(2), pages 153-175, May.
  15. Modigliani, Franco, 1982. " Debt, Dividend Policy, Taxes, Inflation and Market Valuation," Journal of Finance, American Finance Association, vol. 37(2), pages 255-73, May.
  16. Sinn, Hans-Werner, 1980. "Ökonomische Entscheidungen bei Ungewißheit," Monograph, Mohr Siebeck, Tübingen, edition 1, number urn:isbn:9783169427024, Octomber.
  17. Miller, Merton H, 1977. "Debt and Taxes," Journal of Finance, American Finance Association, vol. 32(2), pages 261-75, May.
  18. Robert Dekle & Kenneth Kletzer, 2002. "Domestic Bank Regulation and Financial Crises: Theory and Empirical Evidence from East Asia," NBER Chapters, in: Preventing Currency Crises in Emerging Markets, pages 507-558 National Bureau of Economic Research, Inc.
  19. Kenneth Kletzer & Robert Dekle, 2001. "Domestic Bank Regulation and Financial Crises," IMF Working Papers 01/63, International Monetary Fund.
  20. Charles W. Calomiris & Andrew Powell, 2000. "Can Emerging Market Bank Regulators Establish Credible Discipline? The Case of Argentina, 1992-1999," NBER Working Papers 7715, National Bureau of Economic Research, Inc.
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Citations

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Cited by:
  1. Jakob Eberl & Darko Jus, 2012. "Evaluating policies to attain the optimal exposure to nuclear risk," RSCAS Working Papers 2012/50, European University Institute.
  2. Damien S.Eldridge & Heajin H.Ryoo & Axel Wieneke, 2012. "Bank Capital Regulation with Asymmetric Countries," Working Papers 2012.08, School of Economics, La Trobe University.
  3. Powell, Andrew & Maier, Antonia & Miller, Marcus, 2012. "Prudent Banks and Creative Mimics: Can we tell the difference?," CAGE Online Working Paper Series 76, Competitive Advantage in the Global Economy (CAGE).
  4. Maier, Ulf & Haufler, Andreas, 2013. "Regulatory competition in credit markets with capital standards as signals," Annual Conference 2013 (Duesseldorf): Competition Policy and Regulation in a Global Economic Order 79769, Verein für Socialpolitik / German Economic Association.
  5. Dell'Ariccia, Giovanni & Marquez, Robert, 2006. "Competition among regulators and credit market integration," Journal of Financial Economics, Elsevier, vol. 79(2), pages 401-430, February.
  6. Valeriya Dinger & Sven Steinkamp & Frank Westermann, 2012. "The Tragedy of the Commons and Inflation Bias in the Euro Area," CESifo Working Paper Series 4036, CESifo Group Munich.
  7. Hans-Werner Sinn, 2002. "The New Systems Competition," NBER Working Papers 8747, National Bureau of Economic Research, Inc.
  8. Shuyun May Li, 2008. "Costly External Finance, Reallocation, and Aggregate Productivity," Department of Economics - Working Papers Series 1044, The University of Melbourne.
  9. Michael Keen, 2011. "The Taxation and Regulation of Banks," IMF Working Papers 11/206, International Monetary Fund.
  10. Kersten Kellermann, 2011. "Too big to fail: a thorn in the side of free markets," Empirica, Springer, vol. 38(3), pages 331-349, July.
  11. Schüler, Martin, 2003. "Incentive Problems in Banking Supervision: The European Case," ZEW Discussion Papers 03-62, ZEW - Zentrum für Europäische Wirtschaftsforschung / Center for European Economic Research.
  12. Sharma, Anurag & Jha, Raghbendra, 2012. "Fiscal deficits, banking crises and policy reversal in a semi-open economy," Economic Modelling, Elsevier, vol. 29(2), pages 271-282.
  13. repec:cge:warwcg:75 is not listed on IDEAS
  14. International Monetary Fund, 2006. "Regulatory Capture in Banking," IMF Working Papers 06/34, International Monetary Fund.
  15. Dag Morten Dalen & Trond Olsen, 2003. "Regulatory Competition and Multi-national Banking," CESifo Working Paper Series 971, CESifo Group Munich.
  16. Giancarlo Corsetti & Michael P. Devereux & John Hassler & Gilles Saint-Paul & Hans-Werner Sinn & Jan-Egbert Sturm & Xavier Vives, 2011. "Chapter 5: Taxation and Regulation of the Financial Sector," EEAG Report on the European Economy, CESifo Group Munich, vol. 0, pages 147-169, 02.
  17. Eberl, Jakob & Jus, Darko, 2012. "The year of the cat: Taxing nuclear risk with the help of capital markets," Energy Policy, Elsevier, vol. 51(C), pages 364-373.
  18. Ralf Ewert & Rainer Niemann, 2010. "Limited Liability, Asymmetric Taxation, and Risk Taking - Why Partial Tax Neutralities can be Harmful," CESifo Working Paper Series 3301, CESifo Group Munich.

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