Systemic Risk, International Regulation, and the Limits of Coordination

Abstract

This paper examines the incentives of national regulators to coordinate regulatory policies in the presence of systemic risk in global financial markets. In a two-country and three-period model, correlated asset fire sales by banks generate systemic risk across national financial markets. Relaxing regulatory standards in one country increases both the cost and the severity of crises for both countries in this framework. In the absence of coordination, independent regulators choose inefficiently low levels of macro-prudential regulation. A central regulator internalizes the systemic risk and thereby can improve the welfare of coordinating countries. Symmetric countries always benefit from coordination. Asymmetric countries choose different levels of macro-prudential regulation when they act independently. Common central regulation will voluntarily emerge only between sufficiently similar countries.

Bank Capital Regulations Around the World: What Explains the Differences?

“…The particularly strong negative coefficient on the return on investment variable indicates that high return countries choose less stringent bank capital regulation. This result could be explained if higher returns allow a country to take on more risk through less stringent regulations because lax capital regulations translate into larger losses from bank defaults and fire sales during distress times, as in Kara (2016).…”

“…However, when it comes to bank capital regulations in particular, the level of stringency that maximizes welfare may not be the most stringent regulations at all times for all countries. For example, Kara (2016) shows that high return countries optimally choose less stringent capital regulations. Therefore, the theory does not necessarily predict a positive relationship between more democratic political systems and the stringency of capital regulations.…”

“…In a recent study, Kara (2016) justifies capital regulations under the existence of fire sale externalities and shows that a country with higher returns on investment chooses a lower minimum regulatory capital ratio than a low-return country. In his model, less stringent capital regulations allow banks to invest more in risky assets and hence take a larger exposure to fire sale risk.…”

The Pecking Order of Segmentation and Liquidity-Injection Policies in a Model of Contagious Crises

“…To prove that condition (40) holds, we subtract the LHS of inequality (38) from the LHS of inequality (40) and show that the result is positive:…”

Foreign Asset Accumulation Among Emerging Market Economies: A Case for Coordination

“…See for exampleMendoza (2002) and IMF (2010). 2 Exceptions include Bengui (2013),Sergeyev (2014),Korinek (2016), andKara (2016) where they explicitly consider global macro-prudential policy coordination in the face of systemic financial risk.3 For example,Warnock and Warnock (2009) finds international purchases of U.S. Treasuries significantly lowers U.S. long-term interest rates.…”