Abstract

This chapter discusses recent regulatory reforms and relates them to different market failures in banking, based on the recent theoretical and empirical literature with focus on insights from the recent crisis. We also provide a broader discussion of challenges in financial sector regulation, related to the regulatory perimeter and financial innovation as tools financial market participants use to evade tighter regulatory frameworks. We argue for a dynamic view of regulation that takes into account the changing nature of risk-taking activities and regulatory arbitrage efforts. We also stress the need for a balanced approach between complex and simple tools, a strong focus on systemic in addition to idiosyncratic regulation, and a stronger emphasis on the resolution phase of financial regulation.

Introduction

The recent crisis has given impetus not only to an intensive regulatory reform debate, but also to a deeper discussion on the role of financial systems in modern market economies and the role of financial innovation. While the pre-crisis consensus on the financial system had been that finance serves as the engine for modern market economies, this has been questioned since the recent crisis experience. The fragility risks of finance have claimed a much more important space in the public debate than before the crisis. The pendulum has swung from focus on self-regulation and reliance on market forces to a debate on reducing implicit subsidies and the range of permissible activities for banks.

Historically, the banking system has been one of the most regulated sectors in the economy. As we will discuss further below, this is due to market failures resulting in the external costs of the failure of a specific bank for the rest of the financial system and the real economy. Regulation thus has the task of minimizing the risk of bank failure and its negative effects. On the other hand, there are concerns of overregulation imposing unnecessary costs on financial service providers, reducing their efficiency and ultimately undermining economic growth. The right balance of reducing fragility and maximizing the efficiency of financial intermediation has been thus at the core of regulatory debates over the past decades,with observers pointing to regulatory super-cycles. Regulatory regimes are often tightened after major crises, with heavy emphasis on restrictions and regulatory oversight and then relaxed over time, with more emphasis on market forces and self-regulation.