Aurora Borealis
2 April 2020 CFA Institute Journal Review

Regulatory Competition in Capital Standards: A “Race to the Top” Result (Summary)

  1. Servaas Houben, CFA

This is a summary of "Regulatory Competition in Capital Standards: A 'Race to the Top' Result," by Andreas Haufler and Ulf Maier, published in the Journal of Banking and Finance.

Regulation of capital standards for domestic banks aims to protect national taxpayers and signals bank quality. The current literature suggests that competition between countries on capital standards creates “a race to the bottom” because regulations are viewed as a tax on banks. Several countries have recently increased their capital standards, however, and the authors explain how “a race to the top” occurs as well as the observed cooperation among integrated countries.

What Is the Investment Issue?

Banking is an important source of value—especially in the areas of job creation and tax revenue. Recent international capital standards are meant to ensure greater resilience and consistency in the global banking sector. Previous researchers have mainly focused on the positive externalities of the banking sector (i.e., tax revenue and employment), but this research does not explain why certain countries—for example, Switzerland and the United States—have increased their standards in excess of such international frameworks as Basel III.

Regulations have a structural effect on the banking sector. In Europe, stricter regulations have resulted in a decrease in the number of credit institutions and an increase in the market size of the five largest credit institutions. Additionally, regulations may benefit larger banks not only locally but also internationally. Switzerland increased its capital standards and its European market share has increased, while the less regulated German banks have lost market share.

How Did the Authors Conduct This Research?

Some researchers have assessed bank heterogeneity and screened by regulators and capital requirements. Others have assessed the impact of competition among central banks or capital taxation. None have considered the impact on consumers and taxpayers; some address heterogeneity of firms but not heterogeneity of regulators.

The authors use an idealized model for regulatory competition between two countries that allows for a heterogeneous quality in banks and also includes the effects on taxpayers and consumers. The key variable in the model is the “cutoff” quality of a bank, which depends upon the regulatory ratio of equity capital to total assets. Higher capital standards improve the quality of banks (i.e., the selection effect). In the model, banks are unable to signal their quality to the marketplace, which is in line with empirical evidence that indicates the opaqueness of banks, especially in periods of crisis when capital regulation is an imperfect substitute for bank quality.

What Are the Findings and Implications for Investors and Investment Professionals?

The model shows that a small increase in capital standards in any one country causes an increase in its banking sector profits and improves the welfare of consumers and taxpayers. The higher standard drives the weakest banks from the market, and high-quality banks benefit via a higher loan rate.

In the Nash equilibrium results for two countries, an increase in capital requirements in the home country will reduce loan volume while increasing average bank quality. The increase in capital standards will shift lower-quality banks to the other country and thus will have a negative effect on taxpayers there as they face lower loan quality, higher loan volume, and consequential losses.

The model is shown to be robust to other effects.

The authors find that bank productivity and bank size are positively correlated. Bank quality reduces loan volume but increases the success rate. By considering optimal national capital standards, introducing even a limited capital standard is in the overall interest of the banking sector.

From the two-country model, which takes into account the cost, selection, and tax subsidy effects, the authors find that when the selection and tax subsidy effects are emphasized, a “race to the top” is likely. This results from including the effects of bank loans on real output and tax subsidies. Foreign ownership intensifies the race to the top.

In summary, the authors’ focus on the negative externalities of banking—such as the cost to consumers and taxpayers—enables a comparison of a race to the bottom in capital standards, which shifts the risks to taxpayers, with that of the race to the top in capital standards. As the authors state, “broadening the welfare objective of governments reverses the ‘race to the bottom’ result derived in the existing literature.”

The authors’ work supports and explains the harmonization of capital standards in such highly integrated markets as the European Union.

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