4. International cooperation or race to the bottom? Banking regulation in an integrating financial market

This conclusion is shared for instance by Sinn (2002), who also ventures to apply the systems competition theory to the realm of banking regulation.

From this he derives also a few recommendations in Schüler (2003b) that conclude that current structures of cooperation also with the innovations of the then planned Lamfalussy framework among European financial supervisors would be insufficient incentive – instead it would take a European observatory of systemic risk, which in fact turned out to be valid.

This reflects the result from Chapter 2, that regulatory stringency is the direct link between regulation and stability outcomes, that is credit and leverage in the economy.

This is a central finding of Aiyar’s study based on the most recent financial crisis evidence.

For a more extensive discussion of this and other related results regarding policy coordination in the international economy (and specifically the role of different models of the economy) see Frankel and Rockett (1988).

This is in essence the result of this model as many other models of international regulation, which can be depicted as a classical non-cooperative game of the prisoner’s dilemma form. With each country pursuing an independent regulatory regime, country j with a lower stability preference will find it its dominant strategy to be lax, in response to which it becomes optimal for country i to follow suit and be lax as well. This leaves the countries in a competitive race for regulatory laxity, which would eventually culminate in countries reaching point A, which is the Nash Equilibrium in the absence of cooperation. With increasing integration and repeated interaction, the demand for a coordinated outcome and institutions to stabilize this outcome will increase.

See R. J. Herring, 2007, for a discussion of the reasons for this decision.

See Appendix for the data and specifics on the calculation of these values.

For a discussion of the assumed benefits of universal banking for financial development and growth see Calomiris (1995). For a concise discussion of the moral hazard problems associated with a mixing of commercial banking and investment banking see Boyd and Chang (1998).

Some analysts also find that there are implications for financial stability particularly for bank-based systems, since with the threat of dis-intermediation becoming more immiment, the ease of controlling financial stability through a limited number of financial intermediaries declines (R. G. Rajan & Zingales, 2002).