Dynamic Financial System: Complexity, Fragility and Regulatory Principles

42 Pages Posted: 17 Jan 2013  

Thomas S.Y. Ho

Global Advanced Technology Corp

Hans R. Stoll

Vanderbilt University - Finance

Miguel Palacios

Haskayne School of Business, University of Calgary

Date Written: February 2013

Abstract

A financial system improves the allocation of real resources and enhances the performance of the production economy, but these benefits are offset in part by the risk of financial distress and the associated deadweight loss resulting from bankruptcy costs. We argue that “tiers” of financial claims increase complexity and fragility of the financial network. In equilibrium, the financial system grows relative to the real economy as the allocation of funds and risks becomes more sophisticated and as more financial claims are tiered. Growth is limited by the risk of a tiered, complex financial network and by the need to set aside additional capital as the financial sector grows. We discuss several sources of fragility in the financial system. We propose that regulators should limit the breaks in the system and do more to improve the resiliency of the network and less on individual issues that are only symptoms of fundamental problems of a network. We advocate a market based system of regulation in which market participants regulate each other, to a degree. In order for this to be feasible, the financial network must be organized according to three principles: trading transparency, competitive markets and competitive regulators, and incentive alignment of participants. Insofar as these regulatory approaches are successful in limiting network fragility, capital requirements can be reduced. Regulators should keep in mind this tradeoff between capital and regulation. With regard to regulatory policy, regulators should let the three principles be their guide in adapting to the evolving financial system rather than implementing narrowly conceived regulations that are quickly outmoded.

Suggested Citation

Ho, Thomas S.Y. and Stoll, Hans R. and Palacios, Miguel, Dynamic Financial System: Complexity, Fragility and Regulatory Principles (February 2013). Financial Markets, Institutions & Instruments, Vol. 22, Issue 1, pp. 1-42, 2013. Available at SSRN: https://ssrn.com/abstract=2202039 or http://dx.doi.org/10.1111/fmii.12002

Thomas S.Y. Ho

Global Advanced Technology Corp ( email )

88 Pine Street, 2nd Floor
New York, NY 10005
United States
212-785-9630 (Phone)

HOME PAGE: http://www.thomasho.com/mainpages/homepage.asp

Hans R. Stoll

Vanderbilt University - Finance ( email )

401 21st Avenue South
Nashville, TN 37203
United States
615-322-3671 (Phone)
615-343-7177 (Fax)

Miguel Palacios

Haskayne School of Business, University of Calgary ( email )

2500 University Drive, NW
Calgary, Alberta T2N 1N4
Canada

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