On the Interconnectedness of Regulatory Policy and Markets: Lessons from Banking

Abstract

Capital requirements are an important regulatory device for the management of systemic risk in the banking industry. A puzzling fact is the existence of widespread over-compliance of banks regarding national and international regulatory capital requirements. Some light is shed on this pattern by studying bank capitalization decisions using 1,267 banks from twenty-nine OECD countries. The effect of market pressure (competition) on bank capitalization is found to be positive, whereas the direct effect of regulation is ambiguous. Three points can be made. First, the effectiveness of regulation must be evaluated taking into account the – often overlooked – indirect effects. Secondly, the impact of regulation can be amplified by competitive forces when there are synergies between regulatory and market pressures. Such synergies seem to have played a key role in the widespread adoption and effectiveness of international regulatory capital requirements (the Basle Accord). And thirdly, the prospects for international regulatory convergence in any area are influenced by the interconnectedness (synergies vs. rivalries) between regulatory and market processes.