Bank Regulation, Macroeconomic Management, and Monetary Incentives in OECD Economies

This paper argues that banks operating in systems where monetary and regulatory authority are unified in a central bank expect and receive preferential monetary policies, and so act less prudently than do banks in non-unified systems. These incentives arise when the natural tension between counter-cyclical monetary policy and pro-cyclical regulatory policy is resolved in ways that benefit the banking sector. I test the hypothesis using time series cross-sectional regression models that exploit two types of policy interventions—accession to the European monetary union, and several reassignments of domestic regulatory authority—within OECD countries from 1992 to 2009, the period during which the international Basel accords harmonized key aspects of national regulatory standards. The results strongly support the claim that there is a relationship between risk behaviors of banks and the location of regulatory and monetary authority.