The Structure of Financial Supervision: A Game Theoretic Approach

Abstract

Consolidation or fragmentation for financial regulators? This debate has gained importance since the 2007-2009 financial crisis. The financial services sector has changed considerably over the last 25 years. Financial institutions have evolved from domestic firms engaged in distinct insurance, securities, and banking services into integrated financial services conglomerates offering a broad range of financial products across the globe. These conglomerates and their products now appear even in the most unexpected places, wearing all manner of disguises, and the task of regulating them has grown astronomically. Given these developments, an assessment of the architecture of financial regulators in different parts of the world is long overdue.

This paper aims to assess the existing structures of financial supervision using game theory concepts. The paper develops a game theory matrix describing how two regulators working in the same field are expected to interact with each other. Possible market failures and possible solutions are identified and applied in order to assess the existing financial regulatory structures. The results of this analysis help shed light on why countries keep on switching, in what seems like a random move, from one financial supervisory structure to the other.

The paper concludes with an application in Public Choice theory providing a possible solution to the problem of regulators’ incentives identified by this paper, a problem which might lead to lack of regulation which in turn could result in a financial crisis.

Keywords: Financial regulation, game theory, public choice, consolidation or fragmentation

JEL Classification: C70, C72, G20, G28, G38, H11, H77, K20, K23, L51, M52