National Interests, Spillovers and Macroprudential Coordination

This paper presents a simple two-region banking model of liquidity mismatch to study the strategic interactions between national regulators. I show that banks hold insufficient liquidity, which has repercussions for other banks in an international financial market. The model justifies coordinated prudential liquidity regulation due to an international fire-sale externality. However, I theoretically and empirically argue that domestically oriented regulators from jurisdictions with a smaller banking sector do not internalize the global benefits of regulation and therefore do not adhere to international standards. The model justifies capital controls if countries do not cooperate. Although capital controls improve the welfare of regulating economies, they also align the interest of free-riding countries with international regulation.