## 3. Choice of Jurisdiction, Interest Rate Differential, and Capitalization

## Source details

**Canonical URL:** [3. Choice of Jurisdiction, Interest Rate Differential, and Capitalization](https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2006/_wp0634.pdf)

## Other formats

- [Markdown version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2006/_wp0634.pdf.md)
- [Structured JSON version](/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2006/_wp0634.pdf.json)

---

### Introduction
- Banking is highly regulated and supervised; compliance costs can be a significant share of operating costs and influence institutions’ behavior, the supply of financing, and incentives to save.
- Regulatory capture: regulated institutions may exercise excessive influence on the regulator; a captured regulator acts primarily in the interests of the regulatees rather than the public mandate.
- Finance/banking features that shape capture: asymmetric information, systemic effects, inherent risk, confidence effects, externalities from competition, and bank heterogeneity.
- Model highlights:
  - Banks may welcome regulation; some banks may favor stricter capital requirements (minimum CAR) than is socially optimal.
  - Banks’ regulatory preferences depend on financial condition and can shift after large shocks.
  - Jurisdictions competing for financial institutions need not converge to lax regulation; jurisdictions can differentiate and attract like-minded institutions.

### Susceptibility of Banking Regulation to Capture
- Features increasing susceptibility:
  - Concentration of large institutions and organized banking associations able to lobby and participate in public debate.
  - Close contact between regulators and banks (on-site/off-site inspections) and legal consultation requirements.
  - High technical complexity, need for specialized skills and data, and confidentiality requirements that limit outsider verification.
  - Career mobility from regulators to banks and political connections of banks.
- Empirical/literature evidence (selected examples cited in the source):
  - Kane (1990, 2001) on the U.S. savings and loan industry.
  - Debates on inter-regional branching and deposit insurance (Abrams and Settle, 1993; Kroszner and Strahan, 2000).
  - Rosenbluth and Schaap (2003) on electoral rules and regulatory bias.
  - Franchise value literature: incumbent banks support entry barriers (Boyd and De Nicoló, 2003).
  - Basel II consultations as arenas for attempted capture (European Shadow Financial Regulatory Committee, 2003).
  - Faster adoption of prudential frameworks in transition countries (Siegelbaum and others, 2002).
  - Capture effects on nonbank financial regulation and accounting (Woodward, 1998; Godfrey and Langfield-Smith, 2004).

### A Model of Bank Regulation with Moral Hazard
- Setup and agents:
  - Asset choice: risky asset with return r (support [0,∞], distribution f(r)) versus safe asset with fixed return s.
  - Financing: capital K and deposits D; deposit rate i.
  - Assumptions: E(r) > s > i and 0 ≤ L ≤ D+K; limited liability implies depositors bear downside in very bad outcomes.
  - Without prudential constraints and with risk-neutral banks, first-order condition leads to full investment in the risky asset.
  - Depositors are risk-averse (utility U(.), U′ > 0, U′′ < 0) and equate risk-adjusted expected return on deposits to return on the safe asset; deposit rate responds positively to aggregate risky lending (i_L > 0).

- Risk-weighted minimum capital adequacy requirement (CAR, Cooke ratio):
  - Requirement: K/L ≥ χ.
  - If binding for a bank: K = χD/(1-χ); that bank invests K/χ in risky asset and (D+K-K/χ) in safe asset.
  - Aggregate supply of risky lending A(L) is decreasing in χ; result ∂A/∂χ < 0 (equation (5) in the source).

- Who sets χ? Three cases analyzed:
  1. Capture by all banks collectively:
     - Banks choose χ to maximize total bank profits (collective objective); first-order condition yields collective optimum (equation (8)).
     - Banks voluntarily submit to capital requirements because they internalize the financing-cost externality across banks.
     - An increase in variance of K (capitalization spread) tends to reduce the χ chosen collectively.
  2. Capture by a majority bank coalition:
     - The median bank determines χ (median voter theorem).
     - If CAR not binding on median bank, median chooses χM = KM/LM (median bank’s actual ratio of capital to risky assets) (equation (10)).
     - If CAR is binding on the median bank, median chooses χMB (equation (12)).
     - Ordering: χM > χMB > χC (the CAR chosen by a coalition of well-capitalized banks generally exceeds the collective optimum χC).
     - Uncertainty about future capitalization leads the coalition to choose a lower χ; desired minimum CAR may be cyclical.
  3. Determination through lobbying:
     - With significant-size banks (e.g., two banks j = 1,2), each expends lobbying λj; equilibrium χ is a weighted average of each bank’s unconstrained CAR (χj = Kj/(Dj + Kj)) according to lobbying effort (equation (15)).
     - First-order conditions for lobbying given by equations (16) and (17); equilibrium lobbying balances marginal lobbying costs and marginal benefits (equation (19)).
     - Comparative statics: larger D2 → bank 2 lobbies harder → higher χ; poorly-capitalized banks lobby harder when the constraint is binding or when K1 is lower.

- Socially optimal CAR:
  - With externalities only among banks and depositors compensated ex ante, the socially optimal minimum CAR corresponds to the banks acting collectively (equation (8)).
  - Including costs of bank failure to borrowing firms, employees, suppliers, or elastic supply of deposits would generally raise the social planner’s preferred CAR above the bank-collective choice.

- Extensions and other prudential measures:
  - Asset-side spillovers, competitive effects, and dynamic considerations (entry/exit, franchise value, forbearance) matter.
  - Other prudential requirements (limits on large exposures, sectoral concentration, market risk limits, liquidity requirements, prompt corrective action) reduce systemic risk and may be favored by incumbents even at private cost.
  - Transparency and market discipline can substitute for prudential limits; strong banks favor transparency more than weak banks; weak banks may attempt to mask information.
  - Deposit guarantee schemes: blanket guarantees weaken depositors’ sensitivity to bank risk and may increase incentives for banks to capture regulators, since banks largely fund guarantee schemes and guarantees reduce depositors’ monitoring.

### Competition Between Jurisdictions
- Conventional concern: regulatory competition leads to a “race to the bottom” as institutions relocate to jurisdictions with less onerous regulations.
- Model insight: competing jurisdictions need not converge to lax regulation; jurisdictions weigh direct regulatory costs against higher financing costs associated with a reputation for lax prudential rules.
- Sorting and differentiation:
  - Jurisdictions can evolve into “clubs” of similar institutions: some dominated by well-capitalized banks favoring higher CARs; others attract weaker banks seeking looser regulation.
  - Two-jurisdiction example (X and Y):
    - Suppose χX > χY and iX < iY (X imposes higher CAR and has lower funding costs).
    - Entry choice for a bank with capital K depends on whether CARs bind and on the interest differential:
      - If K > χX D/(1-χX) (CAR nowhere binding), entrant prefers X (lower funding cost).
      - If K is lower, entrant faces three cases: enter X with CAR binding, enter Y with CAR nonbinding, or enter Y with CAR binding; expected profits given by equations (20)–(22).
    - Poorly capitalized entrants are more likely to prefer the jurisdiction with weaker CAR.
  - Implication: jurisdictions may specialize and regulatory regimes need not converge; constituent characteristics become self-reinforcing and more homogeneous.

### Conclusions and Policy Implications
- Key conclusions:
  - Financial institutions may favor prudential regulation because of systemic externalities; some dominant institutions may prefer regulation that is more restrictive than the social optimum.
  - Financial sector regulators are susceptible to capture due to complexity, confidentiality, concentrated industry interests, political connections, and career links.
  - Regulatory capture is not uniformly pernicious: bank-favored regulations can promote financial stability and align with social welfare in many instances.
  - Capture can impose costs: restricted competition, excessive constraints on risky lending, and adverse effects on entrants and users of financial services.
  - Regulatory regimes across countries will differ; weak financial sectors are likely correlated with weak regulation/supervision, and large negative shocks can induce regulatory forbearance or loosening.

- Policy recommendations and governance considerations:
  - Design governance arrangements for regulators and supervisors to balance independence from undue influence, accountability, and industry expertise.
  - Consider trade-offs in regulator funding: industry fees reduce dependence on government budgets but may increase perceived obligation to regulatees.
  - Structure regulator remuneration and career incentives to reduce incentives for staff to seek lucrative positions in regulated institutions.
  - Standard-setting bodies and international institutions should account for cross-country heterogeneity in regulatory and supervisory strength and the possibility that financial weakness may cause poor regulation/supervision, not only the reverse.
  - Educate financial institutions about their “enlightened self interest” to facilitate adoption of beneficial prudential measures.

*Source: _wp0634 - 3. Choice of Jurisdiction, Interest Rate Differential, and Capitalization (IMF working paper section).*

### References..............................................................................................................

### _wp0634 - References..............................................................................................................

### References
- References................................................................................................................................22

### Figures
- 1.  Optimal Minimum CAR for the Median Bank ...................................................................12
- 2.  Choice of Jurisdiction, Interest Rate Differential, and Relative Minimum CAR ...............19

*Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2006/_wp0634.pdf*

### 3.  Choice of Jurisdiction, Interest Rate Differential, and Capitalization ................................19

### 3. Choice of Jurisdiction, Interest Rate Differential, and Capitalization

### Introduction
- Banking is highly regulated and supervised; compliance costs can be a significant share of operating costs and influence institutions’ behavior, the supply of financing, and incentives to save.
- Regulatory capture is the possibility that regulated institutions exercise excessive influence on the regulator; a captured regulator acts primarily in the interests of the regulatees rather than the public mandate.
- Finance/banking is characterized by asymmetric information, systemic effects, inherent risk, confidence effects, externalities from competition, and bank heterogeneity; these characteristics shape how capture operates in banking.
- The paper develops a model showing:
  - banks may welcome regulation and some may favor stricter regulation (capitalization requirements) than socially optimal;
  - banks’ regulatory preferences are contingent on their financial condition and can shift after large shocks;
  - jurisdictions competing for financial institutions need not converge to low regulation; jurisdictions can differentiate and attract like-minded institutions.

### Susceptibility of Banking Regulation to Capture
- Features increasing susceptibility:
  - Concentration of large institutions and organized banking associations able to lobby and participate in public debate.
  - Banking regulators’ close contact with banks (on-site/off-site inspections) and legal consultation requirements.
  - High technical complexity, need for specialized skills and data, and confidentiality requirements that limit outsider verification.
  - Career mobility from regulators to banks and political connections of banks.
- Empirical and literature evidence (selected examples from the source):
  - Kane (1990, 2001): U.S. savings and loan industry influence on regulation and resolution of the crisis.
  - Debates on inter-regional branching and deposit insurance in the United States reflecting conflicts among banks (Abrams and Settle, 1993; Krozner and Strahan, 2000).
  - Rosenbluth and Schaap (2003): electoral rules affect extent to which bank regulation favors producers over consumers.
  - Franchise value literature: incumbent banks support entry barriers (Boyd and De Nicoló, 2003).
  - Basel II consultations as arenas for attempted capture (European Shadow Financial Regulatory Committee, 2003).
  - Faster adoption of prudential frameworks in transition countries versus corporate sector reform (Siegelbaum and others, 2002).
  - Capture may affect nonbank financial regulation and accounting (Woodward, 1998; Godfrey and Langfield-Smith, 2004).

### A Model of Bank Regulation with Moral Hazard
- Setup and behavior:
  - Each bank chooses between a risky asset with return r (support [0,∞], distribution f(r)) and a safe asset with fixed return s.
  - Banks finance with capital K and deposits D; deposit rate is i; assumption E(r) > s > i and 0 ≤ L ≤ D+K.
  - Limited liability implies depositors bear downside in very bad outcomes; with risk-neutral banks, the bank’s first-order condition leads to investing fully in the risky asset absent prudential constraints.
  - Depositors are risk-averse (utility U(.), U′ > 0, U′′ < 0) and face an “either/or” decision: bank deposits or a risk-free investment yielding sD, sD < s.
  - Equilibrium for depositors equates risk-adjusted expected return on deposits to return on safe asset, leading to deposit rate response i_L > 0: depositors demand higher compensation the more aggregate risky lending.

- Effect of a risk-weighted minimum capital adequacy requirement (CAR, Cooke ratio):
  - Requirement: K/L ≥ χ.
  - If binding for a bank, K = χD/(1-χ) and that bank invests K/χ in risky asset and (D+K-K/χ) in safe asset.
  - Aggregate supply of risky lending A(L) is decreasing in χ; formula given in source and result ∂A/∂χ < 0 (equation (5)).

- Who sets χ? Three cases analyzed:
  1. Capture by all banks collectively:
     - Banks choose χ to maximize total bank profits (collective objective); first-order condition yields collective optimum given by equation (8).
     - Banks voluntarily submit to capital requirements because they internalize the financing-cost externality across banks.
     - An increase in variance of K (capitalization spread) tends to reduce the χ chosen collectively.
  2. Capture by a majority bank coalition:
     - The median bank determines χ (median voter theorem).
     - If CAR not binding on median bank, median chooses χM = KM/LM = median bank’s actual ratio of capital to risky assets (equation (10)).
     - If CAR is binding on the median bank, the median chooses χMB given by equation (12).
     - The CAR chosen by a coalition of well-capitalized banks generally exceeds the collective optimum: χM > χMB > χC (collective optimum χC).
     - Uncertainty about future capitalization leads the coalition to choose a lower χ; banks’ desired minimum CAR may be cyclical.
  3. Determination through lobbying:
     - With significant-size banks (e.g., two banks j = 1,2), each expends lobbying λj; equilibrium χ is a weighted average of each bank’s unconstrained CAR (χj = Kj/(Dj + Kj)) according to lobbying effort (equation (15)).
     - First-order conditions for lobbying given by equations (16) and (17); equilibrium lobbying balances marginal lobbying costs and marginal benefits (equation (19)).
     - Comparative statics: e.g., larger D2 → bank 2 lobbies harder → higher χ; poorly-capitalized banks lobby harder when constraint is binding or when K1 is lower.

- Socially optimal CAR:
  - In the model as specified (externalities only among banks; depositors compensated ex ante), the socially optimal minimum CAR corresponds to banks acting collectively (equation (8)).
  - Extending the model to include costs of bank failure to borrowing firms, employees, suppliers, or elastic supply of deposits would generally raise the social planner’s preferred CAR above the bank-collective choice.

- Extensions and other prudential measures:
  - Additional interactions (asset-side spillovers, competitive effects) and dynamic considerations (entry/exit, franchise value, forbearance) matter.
  - Other prudential requirements (limits on large exposures, sectoral concentration, market risk limits, liquidity requirements, prompt corrective action) reduce systemic risk and may be favored by incumbent banks even at private cost.
  - Transparency and market discipline can substitute for prudential limits; strong banks favor transparency more than weak banks, and weak banks may attempt to mask information—thus capture vulnerabilities in transparency rules mirror those for capitalization requirements.
  - Deposit guarantee schemes: blanket guarantees weaken depositors’ sensitivity to bank risk and may increase incentives for banks to capture regulators, since banks largely fund guarantee schemes and guarantees reduce depositors’ monitoring.

### Competition Between Jurisdictions
- Conventional fear: regulatory competition leads to a “race to the bottom” as institutions relocate to jurisdictions with less onerous regulations.
- Model insight: competing jurisdictions need not converge to lax regulation. Jurisdictions weigh direct regulatory costs against higher financing costs associated with a reputation for lax prudential rules.
- Sorting and differentiation:
  - Jurisdictions can evolve into “clubs” of similar institutions: some dominated by well-capitalized banks favoring higher CARs; others attract weaker banks seeking looser regulation.
  - Example with two jurisdictions X and Y:
    - Suppose χX > χY and iX < iY (X imposes higher CAR and has lower funding costs).
    - An entrant with capital K will choose jurisdiction based on whether CARs bind and on interest differential:
      - If K > χX D/(1- χX) (CAR nowhere binding), entrant prefers X (lower funding cost).
      - If entrant’s K is lower, three cases: enter X with CAR binding, enter Y with CAR nonbinding, or enter Y with CAR binding; expected profits for each case given by equations (20)-(22).
    - Poorly capitalized entrants are more likely to prefer the jurisdiction with weaker CAR.
  - Implication: jurisdictions may specialize and regulatory regimes need not converge; characteristics become self-reinforcing and constituencies more homogeneous.

### Conclusions and Policy Implications
- Key conclusions:
  - Financial institutions may favor prudential regulation because of systemic externalities; some dominant institutions may prefer regulation that is more restrictive than the social optimum.
  - Financial sector regulators are susceptible to capture due to complexity, confidentiality, concentrated industry interests, political connections, and career links.
  - Regulatory capture is not uniformly pernicious: bank-favored regulations can promote financial stability and align with social welfare in many instances.
  - Nevertheless, capture can impose costs: restricted competition, excessive constraints on risky lending, and adverse effects on entrants and users of financial services.
  - Regulatory regimes across countries will differ; weak financial sectors are likely correlated with weak regulation/supervision, and large negative shocks can induce regulatory forbearance or loosening.
- Policy recommendations and governance considerations (derived from the analysis):
  - Design governance arrangements for regulators and supervisors to balance independence from undue influence, accountability, and industry expertise.
  - Consider trade-offs in regulator funding: industry fees reduce dependence on government budgets but may increase perceived obligation to regulatees.
  - Structure regulator remuneration and career incentives to reduce incentives for staff to seek lucrative positions in regulated institutions.
  - Standard-setting bodies and institutions (e.g., IMF, World Bank) should account for:
    - cross-country heterogeneity in regulatory and supervisory strength;
    - the possibility that financial weakness may cause poor regulation/supervision, not only the reverse.
  - Educate financial institutions about their “enlightened self interest” to facilitate adoption of beneficial prudential measures.

*Source: _wp0634 - 3. Choice of Jurisdiction, Interest Rate Differential, and Capitalization_ (IMF working paper section).*

### REFERENCES

### _wp0634 - REFERENCES

### Theoretical contributions and political economy of regulation
- Abrams, Burton A., and Russell F. Settle, 1993, “Pressure-group Influence and Institutional Change: Branch-banking Legislation During the Great Depression,” Public Choice, Vol. 77, pp. 687-705.
- Drazen, Allan, 2000, Political Economy in Macroeconomics, (Princeton N.J.: Princeton University Press).
- Laffont, Jean-Jacques, and Jean Tirole, 1991, “The Politics of Government Decision-Making: A Theory of Regulatory Capture,” Quarterly Journal of Economics, pp. 1089-1127.
- Laffont, Jean-Jacques, and Jean Tirole, 1993, A Theory of Incentives in Procurement and Regulation (Cambridge, Massachusetts: MIT Press).
- Laffont, Jean-Jacques, 1999, “Political economy, information and incentives,” European Economic Review, Vol. 43, pp. 649-69.
- Stigler, G., 1971, “The Economic Theory of Regulation,” Bell Journal of Economics, Vol. 2, pp. 3–21.
- Tiebout, C., 1956, “A Pure Theory of Local Expenditures,” Journal of Political Economy, Vol. 64, pp. 416–24.

### Banking regulation, competition among regulators, and moral hazard
- Boyd, John H., and Gianni De Nicoló, 2003, “Bank Risk Taking and Competition Revised,” IMF Working Paper 03/114 (Washington: International Monetary Fund).
- Dell’Ariccia, Giovanni, and Robert Marquez, 2001, “Competition Among Regulators,” IMF Working Paper 01/73 (Washington: International Monetary Fund).
- Kane, Edward J, 1990, The S&L Insurance Mess: How Did It Happen? (Washington: Urban Institute Press).
- Kane, Edward J, 2001, “Dynamic Inconsistency of Capital Forbearance: Long-Run vs. Short-Run Effects of Too-Big-to-Fail Policymaking,” Pacific Basin Financial Journal, Vol. 9, No. 4 (August), pp. 281–99.
- Kroszner, Randall S., and Philip E. Strahan, 2000, “Obstacles to Optimal Policy: The Interplay of Political and Economics in Shaping Bank Supervision and Regulation Reforms,” NBER Working paper No. 7582 (Cambridge, Massachusetts: National Bureau of Economic Research).
- Rosen, Richard J., 2003, “Is Three A Crowd? Competition Among Regulators in Banking” Journal of Money, Credit and Banking, Vol. 35 No. 6, pp. 967–98.
- Sinn, Hans-Werner, 2001, “Risk Taking, Limited Liability and the Competition of Bank Regulators,” NBER Working Paper No. 8669 (Cambridge, Massachusetts: National Bureau of Economic Research).
- Weinberg, John A., 2002, “Competition Among Bank Regulators,” Economic Quarterly- Federal Reserve Bank of Richmond, Vol. 88 No. 4, Fall, pp. 10–36.
- Rosenbluth, Frances, and Ross Schaap, 2003, “The Domestic Politics of Banking Regulation,” International Organization, Vol. 57, Spring, pp. 307–36.
- European Shadow Financial Regulatory Committee, 2003, “Bank Supervisors’ Business: Risk Management of Systemic Stability,” Statement No. 16 (Brussel: Center for European Policy Studies).

### Regulatory capture, independence, and governance of financial oversight
- Godfrey, Jayne M., and Ian A. Langfield-Smith, 2004, “Regulatory Capture in the Globalization of Accounting Standards,” Monash University Working Paper (Victoria, Australia: Monash University).
- Quintyn, Marc, and Michael W. Taylor, 2004, “Should Financial Sector Regulators be Independent?” IMF Economic Issues Paper No. 32 (Washington: International Monetary Fund).
- Woodward, Susan E., 1998, “Regulatory Capture at the U.S. Securities and Exchange Commission,” Sand Hill Econometrics Working Paper (Palo Alto California: Sand Hill Econometrics). Available on the Internet at http://www.sandhillecon.com/pdf/RegulatoryCapture.pdf.
- Laffont, Jean-Jacques, and Jean Tirole, 1991, “The Politics of Government Decision-Making: A Theory of Regulatory Capture,” Quarterly Journal of Economics, pp. 1089-1127. (listed also under theoretical contributions)

### Case studies, crises, and transition economies
- Choi, Jin-Wook, 2002, “Regulatory Forbearance and Financial Crisis in South Korea,” Asian Survey, Vol. 4, No. 2, pp. 251-275.
- Siegelbaum, Paul J., Khaled Sherif, Michael Borish, and George Clarke, 2002, Structural Adjustment in Transition: Case Studies from Albania, Azerbaijan, Kyrgyz Republic and Moldova, World Bank Discussion Paper No. 420 (Washington: World Bank).
- Ngo, Phong T.H., 2004, “International Financial Regulation, Regulatory Risk and the Cost of Capital: A Summary,” Working Paper (Camberra: School of Economics, Australian National University).

*Reference list as provided in _wp0634 - REFERENCES*

---


_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/wp/2006/_wp0634.pdf_