Financial Liberalisation and Capital Regulation in Open Economies

We model the interaction between two economies where banks exhibit both adverse selection and moral hazard and bank regulators try to resolve these problems. We find that liberalising bank capital flows between economies reduces total welfare by reducing the average size and efficiency of the banking sector. This effect can be countered by forcing international harmonisation of capital requirements across economies, a policy reminiscent of the "level playing field" adopted in the 1988 Basle Accord. Such a policy is good for weaker regulators whereas a laissez faire policy under which each country chooses its own capital requirement is better for the higher quality regulator. We find that imposing a level playing field among countries is globally optimal provided regulators’ abilities are not too different. We also show how shocks will be transmitted differently across the two policy regimes.