Capital regulation and trade in banking services

We set up a two-country, regional model of trade in financial services. Competitive firms in each country manufacture untraded consumer goods in an uncertain productive environment, borrowing funds from a bank in either the home or the foreign market. Duopolistic banks can choose their levels of monitoring of firms and thus the level of risk-taking, where the risk of bank failure is ultimately borne by taxpayers in the bank's home country. Moreover, each bank chooses the share of lending allocated to domestic and to foreign firms, respectively, but the bank's overall loan volume may be fixed by a capital requirement set in its home country. In this setting we consider two types of financial integration. A reduction in the transaction costs of cross-order banking reduces aggregate output and increases risk-taking, thus harming consumers and taxpayers in both countries. In contrast, a reduction in the costs of screening foreign firms is likely to be beneficial for banks, consumers, and taxpayers alike.