Bank Capital Regulation with Asymmetric Countries

When financial markets are global, the impacts of national banking regulations extend beyond national borders. While lax regulatory enforcement improves the profitability of home banks, it also increases loan supply, which in turn reduces the global interest rate spreads. In a two-country model we show that each regulator's enforcement choice is affected by the relative size of the national financial market. An authority regulating a smaller market has a smaller impact on global interest rates and therefore a stronger incentive to relax regulatory enforcement.