213 - Regulatory Competition and Bank Risk Taking

DNB Working Papers
Date 27 July 2009

How damaging is competition between bank regulators? This paper develops a model in which both banks’ risk profile and their access to wholesale funding are endogenous. Regulators weigh not only welfare, but also the number of banks under their supervision. Simulations indicate that the gains from consolidating US regulation are moderate, roughly 0.5-1% of GDP. But retaining multiple regulators implies a choice for a financial system that is both more profitable and more fragile. The paper also shows how complex balance sheet items give rise to a gradual rise in bank risk, followed by a sudden interbank crisis. Keywords: regulatory competition, arbitrage, bank risk, liquidity risk, interbank market.  JEL Classification: G21, G28.