Abstract:

Financial regulation is synchronized across countries despite the fact that countries vary widely in their ability to bail-out their banking sector in the event of a financial crisis. This paper addresses the question of whether countries with different fiscal capacity should optimally have different ex-ante minimum bank capital requirements. In an environment with endogenously incomplete markets and overinvestment due to moral hazard and pecuniary externalities, I show that countries with larger fiscal capacity should have lower ex-ante minimum bank capital requirements. This result is the opposite of what one might expect, given that countries with larger fiscal capacity often have stronger moral hazard. I also show that, in addition to a minimum bank capital requirement, regulators in countries with strong moral hazard (those with a concentrated financial sector and large fiscal capacity) should impose a limit on the liabilities pledged by financial institutions in a crisis state. This would entail restricting the amount of put options/CDS contracts sold by financial institutions, among other measures.