In Chapter 1 to Chapter 5 of this study, we analysed the economic factors likely to have an impact on the structure of financial intermediation activity in a particular domestic financial system and in the global financial markets as a whole. We also discussed the principal aspects of strategic positioning and performance of firms engaged in this activity.

The financial flows which are the basis of the preceding discussion are affected dramatically by regulatory factors. Financial services comprise an industry that has usually been, and will inevitably continue to be, subject to significant public authority regulation due to its fiduciary nature and the possibility of social costs associated with institutional failure. Indeed, small changes in financial regulation can bring about truly massive changes in financial activity—such as, for example, significant capital requirements associated with counterparty exposures in swaps and derivatives contracts.

When analysing the effects of regulation on the level of activity in a nation's financial system, it is useful to think of regulation as imposing a set of “taxes” and “subsidies” on the operations of financial firms. On the one hand, the imposition of reserve requirements, interest/usury ceilings and certain forms of financial disclosure requirements, for example, can be viewed as imposing additional implicit “taxes” on a financial firm's activities in the sense that they increase its costs of financial intermediation. On the other hand, regulator-supplied deposit insurance and lender of last resort facilities serve to stabilize financial markets and reduce the risk of systemic failure, thereby lowering the costs of financial intermediation. They can therefore be viewed as implicit “subsidies”.

The difference between these “tax” and “subsidy” elements of regulation can be viewed as the net regulatory burden (NRB) faced by a bank or other financial firm in any given jurisdiction. Private, profit maximizing financial firms tend to migrate towards those financial centres where the NRB is lowest— assuming all other economic factors are the same.