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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.

Suggested Citation

  • Hans-Werner Sinn, 2001. "Risk Taking, Limited Liability and the Competition of Bank Regulators," CESifo Working Paper Series 603, CESifo.
  • Handle: RePEc:ces:ceswps:_603
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    References listed on IDEAS

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    1. Sinn, Hans-Werner, 1980. "Ökonomische Entscheidungen bei Ungewißheit," Monograph, Mohr Siebeck, Tübingen, edition 1, number urn:isbn:9783169427024, March - J.
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    3. Mr. Robert Dekle & Kenneth Kletzer, 2001. "Domestic Bank Regulation and Financial Crises: Theory and Empirical Evidence From East Asia," IMF Working Papers 2001/063, International Monetary Fund.
    4. 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.
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    8. 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.
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    11. Sinn, Hans-Werner, 1997. "The selection principle and market failure in systems competition," Journal of Public Economics, Elsevier, vol. 66(2), pages 247-274, November.
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    14. 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.
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    16. 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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    More about this item

    Keywords

    systems competition; Basel II; banking with limited liability and Lemon bonds;
    All these keywords.

    JEL classification:

    • D8 - Microeconomics - - Information, Knowledge, and Uncertainty
    • H0 - Public Economics - - General

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