thus, be realized with lower costs to banking system A. The optimally in-
duced level of realized quality qA increases until the marginal gains are equal
to the marginal costs of additional realized quality qA (see first-order condi-
tion (10)). A higher quality level corresponds to a lower capital-asset ratio
(see Corollary 4). The rise in quality and the drop in the capital-asset ratio
increase with the integration of the two banking systems. The same holds
true for country B. When country B banks fund country A banks via the
interbank market, qA can partly substitute for eB . qB rises and kB falls.
Higher realized quality in country B increases realized quality in A which
has a positive repercussion on quality in country B and so forth. This positive
interconnection does not lead to a conflict between national supervisors.9
However, supervisors use the higher quality level to lower the required capital-
asset ratio. Hence, integration leads to a higher realized quality and a lower
capital-asset ratio. These two effects compensate for each other so that the
probability of failure remains on an inefficiently low level in the two-country
setup due to the national supervisors’ lacking incentives to internalize foreign
spillovers.10
To sum up, for a regulatory regime to be efficient, it has to force na-
tional supervisors to exchange information on the activity of banks in the
host country and to take costs into account which accrue abroad. In this
framework, efficient information exchange does not lead to a strategic game
in which national supervisors play against eachother, but rather provide the
basis for supervisors to implement an efficient regime.
6 Optimal Supervision in the EU
The inefficiently low probability of failure in the two-country setup derives
from the fact that supervisors do not take foreign spillovers into account
which are the result of a national bank’s breakdown. This is due to the
regulators’ incentives set by their national mandates. The same holds for
9 I abstract here from reputational losses which accrue to supervisors in case of bank-
ruptcy. The reputational losses would accrue as the respective supervisor would obviously
not have been successful in preventing bankruptcy. The supervisor would, thus, be reluc-
tant to reveal information on problems of home banks as long as there is the chance that
the problems would only be of temporary nature. For a model of conflicts of interest in
the supervision of multinational banks in a related context see Holthausen and Roende
(2002).
10 However, if the marginal cost of equity were strictly increasing in equity E , re would be
lower in the two-country setup as the required capital-asset ratio k is lower (see corollary
2). Hence, the probability of failure his lower which mitigates the problem due to the
supervisors’ incentive deficit.
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