Regulating for Financial System Development, Financial Institutions Stability, and Financial Innovation

Abstract

The issues in today’s crisis – and indeed in the most important crises, historically – can best be understood as a manifestation of asymmetric information in an environment of rapid financial innovation. The present paper reviews the asymmetric information and financial innovation frameworks and applies those to major twentieth century U.S. financial crises. The paper posits that financial innovations inexorably create conditions of asymmetric information that can lead to financial crises and panics. Those events are crucial to the development of plain vanilla financial instruments, providing incentives to forgo margins in favor of liquidity. Regulatory attempts to stabilize markets by manipulating bank failures may ultimately result in substantial setbacks to market development.

JEL Classification: E50, G20, N20