International Financial Regulation: The Role of Banking Sector Sizes

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RWP 21-13, November 2021; updated July 2024

This paper presents a simple N region banking model of liquidity mismatch to study the strategic interactions between national regulators. Banks hold insufficient liquidity, which leads to a fire-sale externality in an international financial market, justifying coordinated prudential regulation. However, countries with a smaller banking sector internalize less of the inefficiency and have an incentive to free-ride on foreign regulation. As a consequence, countries cannot agree on common regulatory standards. Further, small countries have a strictly positive marginal cost to regulate, which can also prevent coordination on non-harmonized standards. An empirical section demonstrates that key issues around the implementation of the Basel Agreements are consistent with the implications from the model.

JEL Classifications: D62, F36, F42 G15, G21