Why Prudential Regulation Will Fail to Prevent Financial Crises: A Legal Approach

Abstract

In this paper, I suggest that the regulation of the financial system, especially if the aim is to prevent financial crises, should be focused on dealing with the consequences of the crises, not on trying to avoid their causes, although it may seem counterintuitive at first sight. Contrary to the majority of opinions in the field, I firmly believe that more important than organizing the best possible prudential regulation is having a solid and well-developed financial safety net. Building a strong safety net might not only boost confidence in the financial system and contribute to its stability, but also create the right incentives to avoid reckless risk-taking and better align interests, mainly if there are rules establishing that other financial institutions, creditors and even executives could be held responsible for the trouble caused by any failed financial institution.

The key point I wish to make is that no financial regulation will ever be effective without duly addressing the problem related to the attribution of responsibility for the outcome of failures in the financial system. I believe the success of any financial regulation depends largely on having rules stating that, when crises come, those participants with the power to decide, being them financial institutions, executives or creditors, will suffer legal and economic consequences for the choices (rational or irrational, riskier or safer) they have made.

Keywords: financial crisis, prudential regulation, overregulation, banking supervision, safety net

JEL Classification: G18, G21, G28, G33, K22, K23, K42, L50