A regulatory arbitrage game: Off-balance-sheet leverage and financial fragility

Abstract

This study examines a simple banking system in a game-theoretic framework wherein banks act as self-interested agents to maximize leverage at the expense of overall financial stability. The resultant strategic inefficiency raises concerns about how banks manage the "financial stability" good, which is appropriated into a "tragedy of the commons." We conceptualize the inefficiency using the price of anarchy introduced by Koutsoupias and Papadimitriou (2009). We seek the optimal regulatory framework that minimizes the price of anarchy or the degree of financial fragility.

Keywords

• financial fragility
• congestion games
• price of anarchy
• best response potential