Global lending conditions and international coordination of financial regulation policies

Summary

Focus

There are two main reasons for cross-border regulatory coordination. Firstly, there is the regulatory "race to the bottom". This is a tendency to remove regulation in order to give domestic banks a competitive advantage. Secondly, there is the issue of "leakages". Banks can bypass domestic regulations by setting-up subsidiaries in places with laxer standards. This paper proposes a different mechanism in support of cross-border regulatory coordination. It focuses on the interplay between regulatory policies and global lending conditions.

Contribution

Lending conditions in emerging market economies (the periphery) are greatly impacted by external factors, including what happens in core economies. As a result, such lending conditions do not necessarily accord with the needs of the periphery. This can lead to an inefficient allocation of credit.

Regulatory policy can help to regain some control over lending conditions for the periphery. In practice, this means imposing controls on capital flows, or imposing additional regulation on bank funding. However, such unilateral actions affect the core. The core responds by tightening its own policies. This partly offsets the benefits for the periphery. 

Findings

Policymakers can achieve better outcomes by setting regulatory policies cooperatively. They understand that tightening domestic regulations imposes costs beyond their borders. As a result, with cooperation, cross-border lending is higher, and lending conditions are closer to those that accord with the needs of the periphery.

The median cooperation gain is slightly above 1% at the global level. However, it is not symmetrical. It is about 0 in the core, but around 2% for the periphery. Moreover, although coordinating lending conditions yields larger gains than coordinating regulatory policies, only gains resulting from the coordination of regulatory policies are positive for both regions.

Abstract

Using a model of strategic interactions between two countries, I investigate the gains to international coordination of financial regulation policies, and how these gains depend on global lending conditions. When global lending conditions are determined non-cooperatively, I show that coordinating regulatory policies leads to a Pareto improvement relative to the case of no cooperation. In the non-cooperative equilibrium, one region - the core - determines global lending conditions, leaving the other region - the periphery - in a sub-optimal situation. The periphery then tightens regulatory policy to reduce the cost of sub-optimal lending conditions. Yet, in doing so, it fails to internalise a cross-border externality: tightening regulatory policy in one region limits ex ante borrowing in the other region, which increases the cost of sub-optimal lending conditions for the periphery. The equilibrium with cooperative regulatory policies can then improve on this outcome as both regions take into account the cross-border externality and allow for larger ex ante borrowing, ending in a lower cost of suboptimal lending conditions for the periphery.

JEL classification: D53, D62, F38, F42, G18

Keywords: regulatory policy, global financial conditions, international coordination