Level Playing Fields in International Financial Regulation

In our recently accepted Journal of Finance paper Level Playing Fields in International Financial Regulation, we analyze the costs and benefits of imposing level playing fields in international financial regulation. The cost of level playing fields is that they limit the social benefits of expert regulation in the better-regulated economies, thus shrinking their banking sectors. The benefit is that the banking sector in the less well-regulated economies will be larger and of better quality.

We analyze this trade-off in a number of different setups. In the base case, we allow bankers to be chartered to operate in only one economy, so that multinational banking is impossible. In this case, regulators face a stark choice: international coordination upon a level playing field, which will disadvantage the well-regulated economy, and a laissez faire policy of no international regulation of the playing field, in which case the cherry-picking effect will adversely affect the less well-regulated economy. From a global welfare-maximizing perspective, it turns out to be better to adopt a level playing field, and hence to experience the lowest common denominator effect, when the regulatory abilities in the economies involved aresufficiently similar, because the extent of shrinkage implied by the lowest common denominator effect will be small. By contrast, when regulators’ abilities are very different, the cherry-picking externality is the lesser of the two evils and an unregulated playing field dominates. This leads to the intuitive conclusion that “similar” economies should endeavor to adopt common capital regulation and deposit rates; economies that are very different should not attempt to follow them, but should adopt their own regulation.

After analyzing the base case, we extend our model to allow bankers to apply for licenses in more than one country. Introducing multinational banks into our model allows us to take a more nuanced view of the capital flows that create cherry-picking effects. We analyze two cases: one in which borders are opened after bankers have received their first license, so that banks are obliged to open at home before they seek a foreign license, and one in which bankers can make their first license application anywhere. In both cases we show that, when multinational licenses are awarded optimally, multinational bank properties are invariant to the country in which the first of their licenses was awarded. Cherry-picking effects are therefore a concern only for single-country local banks that fail to attract a second license.

The full paper is available for download here.