Is the International Convergence of Capital Adequacy Regulation Desirable?

The merit of having international convergence of bank capital requirements in the presence of divergent closure policies of different central banks is examined. While the privately optimal level of bank capital decreases with regulatory forbearance (they are strategic substitutes), the socially optimal level of bank capital increases with regulatory forbearance (they are strategic complements). Hence, in optimal regulatory design, the level of minimum bank capital requirement increases with the forbearance in central bank closure policy. The lack of such linkage leads to a spillover from more forbearing to less forbearing economies and reduces the competitive advantage of banks in less forbearing economies. Linking the central bank?s forbearance to its alignment with domestic bankowners, it is shown that in equilibrium a regression towards the worst closure policy may result: the central banks of initially less forbearing economies have to adopt greater forbearance as well.