Sub & Super-modularity in International Policy Coordination for Financial Regulation with Politically Influential Banks

This paper determines the equilibria of international policy coordination game in both cases of submodularity and supermodularity of financial regulatory policies. Moreover, we examine the conditions for financial regulatory policy coordination mechanism to be self-enforcing considering the cross-border externalities caused by multinational banks and the political influences of the banking sectors. Given submodularity of financial regulatory policies with relatively high monitoring costs, when the asymmetry of the political influences of banking sectors is bigger, each country is more likely to reduce regulatory efforts with increased incentives for free riding. Supermodularity of regulatory policies with lower monitoring costs reduces the incentives to free ride regulatory efforts. However, over-sensitive responses to other countries’ policies aggravate financial instability due to multiple equilibria caused by the supermodularity of the regulatory policies. When informational barriers are considered, if noisy signals observed by regulators are reduced, financial instability due to multiple equilibria can be avoided.