Regulatory Trade-offs in Banking

Here is a paper about Basel. Specifically, about the Basel Committee on Banking Supervision. It’s riveting stuff, and well worth a read.* Since the Basel process is substantially about establishing common bank capital standards, the authors (Michael S. Barr and Geoffrey P. Miller) devote some time to considering the effects of regulatory harmonization:

Harmonization creates lock-in that slows regulatory change and inhibits flexibility. Competition, by contrast, would require regulators to innovate to retain jurisdiction over banking organizations. If regulation becomes too burdensome, firms can shift their activities, or organizational structures, to lower-burden jurisdictions. The greater the level of coordination among supervisory authorities, the lower is the level of utility of firms using regulatory arbitrage to evade regulatory burdens. The lower threat from exit reduces incentives on regulators to develop efficient regulation.

That seems like an extremely plausible description of the results of regulatory harmonization. And if harmonization is achieved at a sub-optimal level of regulation, then there are right away obvious costs incurred. But it seems this potential cost should be weighed against the benefits of reducing the returns to regulatory arbitrage. If, in the face of diminishing returns to regulatory arbitrage, banks engage in more “real” economic activity, and if this effect is greater than the cost of a sub-optimal harmonization level, then perhaps regulatory harmonization is not such a bad thing after all.**

On the other hand, here is a paper which was presented at the 2012 meeting of the European Finance Association. The authors (Pascal Frantz and Norvald Instefjord) find, “regulatory diversity can be welfare optimal even though it leads to more regulatory arbitrage activity than regulatory harmonization.” So I don’t know what to tell you.

*I can’t decide if this is sarcastic or not. It’s a good, interesting article. But I’m guessing you probably don’t want to spend an enormous amount of your day parsing it
**To be sure, the thrust of the paper is not “regulatory harmonization is a bad thing”