Optimal Bank Regulation and Fiscal Capacity

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.