International Cooperation on Financial Market Regulation

Abstract: We investigate the incentives of policy makers to form self-enforcing international financial regulation agreements concerning financial market supervision. We model the cooperation of national regulators in a game-theoretical framework that considers financial stability to be an impure public good. Joint national supervisory effort is supposed to increase aggregate welfare in terms of a more stable financial system both on a global and on a local level by simultaneously generating incentives to free-ride. We apply standard methods from industrial organization in order to determine the number of signatories endogenously and analyze the efficiency of multilateral agreements. Our analysis indicates that partial cooperation is always feasible in equilibrium. However, the welfare gains are relatively small compared to potential gains in the socially optimal situation. These results in general highlight the difficulty of reaching an international supervisory agreement. Further analyses show that the incentives to cooperate are particularly sensitive to the existence of additional club benefits for members of a coalition.