5 Regulation in a Two-Country Setup
In the last section, the optimal regulatory scheme was established which a
regulator-supervisor would choose if he took the negative impact of bank
failure on the banking system and the whole economy into account. Let us
think of him as an EU regulator who is able to fully assess the spillover costs
independent of where the banking problem first begins and in which country
the costs accrue. The regulatory scheme derived in the last section could
then be interpreted as the optimal regulation-supervision in the EU as banks
would be forced to internalize the whole negative costs which accrue when
they fail.
Let us assume a setup with two countries A and B. In every country,
there is one bank which represents the national banking system. The terms
”bank” and ”national banking system” are then synonyms. The two banking
systems are assumed to have cross-border linkages via the interbank market.
Country A banks deposit in and take deposits from country B banks and
vice versa. In each country, there is a regulator-supervisor who controls the
national banking system. His national supervisory mandate brings about two
differences in regulation compared to the case with only one supranational
regulator.
To analytically derive these differences, let us modify the closed-banking-
system model of the last two sections. In the two-country setup, the level of
realized quality of country A’s banking system does not longer only depend
on innate quality q0,A and effort eA , but also on the level of realized quality
in country B’s banking system qB :
qA =(1- f)(q0,A + eA) + fqB (15)
where f is the share the home bank invests in the foreign banking system
(0 ≤ f ≤ 1). If the portfolio share of loans to foreign banks is small (low
f), the level of realized quality in country B’s banking system has only a
small impact on realized quality in country A. For the regulator in country
A, q0,A + eA and qB are substitutes. Hence, the quality level qA can either
be achieved by loans to companies whose quality the bank can enhance by
exerting effort eA , or by investing in foreign banks with the quality level qB
(which adds the more to the bank’s quality, the higher the banking systems
are integrated).
As discussed above, regulators with a national mandate do not have an
incentive to take international spillovers into account. Recall that this in-
centive contraint is twofold as national supervisors do not take costs into
account which accrue abroad (incentive constraint) and they cannot access
13