In the modern financial world, banks might be based in one city but lend to people and businesses all over the globe. But while banks themselves are international, the rules that govern their activities are often national.
In a recent research, we explore how these national rules create a global competition for bank ‘equity capital’ – the cushion of funds from shareholders that protects the taxpayer from losses (Bahaj and Malherbe, 2024). National regulators set capital requirements: how much of bank lending must be funded by shareholders rather than depositors. When one country changes its requirements, it triggers a chain reaction that moves money across borders, often with unintended consequences for global financial health.
The host with the most
Our research looks at the ‘host-country rule’, which is the standard for modern international banking. This rule says that if a bank lends money in the UK, it must follow UK capital rules for that loan, even if the bank is, for example, American or German. Because bank equity capital may not be abundantly available globally, countries end up competing for it.
We find that the direction of equity capital flows triggered by a policy change depends on how the given change affects bank profits domestically. It is often assumed that stricter rules drive bank equity capital away because they raise costs. But instead, we find that if capital requirements are relatively loose, raising them can actually make the local banking market more attractive.
This happens because the new rules force all banks to lend a bit less, which prevents them from over-competing and keeps profit margins high. Higher profits then act as a magnet for global investors and capital flows into local banks.
This dynamic can lead to a problem of ‘overshooting’. In our work, we identify two challenging scenarios:
- In good times: when capital is plentiful, national regulators have an incentive to operate with overly tight requirements. They do this since they can attract capital from abroad and make their own systems extra safe. But this siphons money away from other countries.
- In bad times: during downturns, capital can be scarce and regulators might undercut each other. They reduce requirements too much to try and lure money back to their shores, which can lead to a dangerous ‘race to the bottom’, where no one has enough of a safety cushion.
Our analysis shows that these spillovers are a direct result of capital being a limited resource. If capital were abundant, one country’s rules would not affect another’s – but in the real world, investors have limited wealth to put into banks.
In times of crisis: every country for itself
Our research is useful for understanding why financial crises can spread across borders. When banks in one country lose their capital, they don’t just stop lending at home: they often pull back from their lending abroad. Our study provides the framework to see how regulation itself can cause these pullbacks.
In practice, the mechanism that we highlight can operate through a counter-cyclical capital buffer. This is a tool that allows regulators to raise or lower bank capital requirements as the economy changes.
Our research explains a seemingly strange trend: smaller countries use this tool much more often than large ones. Data show that economies like Hong Kong and Norway frequently move their buffers, while large countries like China and the United States rarely do so.
The reason is simple. A small country can attract a lot of capital without moving the needle on global equity returns, making the strategy very effective for them. But if every small country does this at the same time, it creates a ‘tragedy of the commons’, where the global financial system becomes less stable as everyone tries to grab the biggest piece of the pie.
Potential policy responses
The current international financial regulatory system – known as Basel III – could do more to encourage coordination. While the system encourages countries to respect each other’s rules, it doesn’t stop them from setting those rules in a way that hurts their neighbours.
Policy-makers should consider the following:
- Coordinated raises: during economic booms, countries should agree on more modest increases to safety rules to prevent a ‘race to the top’ that drains capital from developing regions.
- Crisis management: during downturns, there should be clear agreements to prevent countries from cutting their buffers too aggressively in a way that creates a race to the bottom.
- Monitoring smaller nations: international bodies should pay closer attention to how the actions of many small countries can add up to a significant global shock.
In the end, our study shows that we cannot view bank safety as a purely national issue. Because money moves freely around the world, a ‘safe’ country might just be one that has successfully taken safety away from its neighbours. Collaboration is the only way to ensure that the global financial system as a whole remains stable.
