Regulation of Banking and Financial Markets

ENCYCLOPEDIA OF LAW AND ECONOMICS: REGULATION AND ECONOMICS, 2nd Edition, A.M. Pacces and R.J. Van den Bergh, eds., Elgar, 2012

Rotterdam Institute of Law and Economics (RILE) Working Paper No. 2011/04

49 Pages Posted: 23 Aug 2011 Last revised: 13 Apr 2017

See all articles by Alessio M. Pacces

Alessio M. Pacces

Amsterdam Law School / Amsterdam Business School; European Corporate Governance Institute

Dirk Heremans

KU Leuven - Center for Economic Studies

Date Written: May 1, 2011

Abstract

This paper is one chapter of the volume “Regulation and Economics” of the second edition of the Encyclopedia of Law and Economics.

The authors review the economics of banking and financial markets and the regulatory response to market failure. Market failure in finance depends on problems of information and externalities. Regulation addresses these problems through conduct of business rules and prudential requirements. This approach has recently proved insufficient to prevent financial crises. Governments and central banks had to step in with massive safety nets in order to prevent financial meltdown. Although the appropriate regulatory response to the global financial crisis is still to be discovered, this chapter tries to draw a few lessons for financial regulation and supervision.

First, prudential regulation and supervision should monitor, and possibly limit, competition between banks and non-banks in order to identify timely new sources of systemic risk. Second, financial stability policies need to strike a difficult balance between ex-ante strictness and ex-post leniency in order to deal with non-quantifiable risks. Moral hazard is not the only determinants of systemic instability; knightian uncertainty also determines instability by suddenly curtailing market and funding liquidity. Third, all financial institutions falling within the regulatory perimeter should have good corporate governance. However, what is good governance for non-financial firms is not necessarily efficient for financial firms due to the quality and quantity of externalities involved. Finally, because systemic externalities are cross-jurisdictional in modern financial markets, at least coordination among monetary and supervisory authorities of different countries is warranted.

Keywords: Regulation, Information, Moral Hazard, Banking, Insurance, Financial Markets, Financial Crisis, Corporate Governance, Uncertainty, Liquidity

JEL Classification: G01, G28, G38, K20, K23

Suggested Citation

Pacces, Alessio Maria and Heremans, Dirk, Regulation of Banking and Financial Markets (May 1, 2011). ENCYCLOPEDIA OF LAW AND ECONOMICS: REGULATION AND ECONOMICS, 2nd Edition, A.M. Pacces and R.J. Van den Bergh, eds., Elgar, 2012 . Available at SSRN: https://ssrn.com/abstract=1914461 or http://dx.doi.org/10.2139/ssrn.1914461

Alessio Maria Pacces (Contact Author)

Amsterdam Law School / Amsterdam Business School ( email )

Roetersstraat 11
Amsterdam, 1018 WB
Netherlands

HOME PAGE: http://www.uva.nl/profiel/p/a/a.m.pacces/a.m.pacces.html

European Corporate Governance Institute ( email )

c/o ECARES ULB CP 114
B-1050 Brussels
Belgium

HOME PAGE: http://https://ecgi.global/users/alessio-pacces

Dirk Heremans

KU Leuven - Center for Economic Studies ( email )

Naamsestraat 69
Leuven, B-3000
Belgium

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