Regulating Financial Change: A Functional Approach

Abstract

How should we think about regulating our dynamically changing financial system? Existing regulatory approaches have two temporal flaws. The obvious flaw, driven by politics and human nature (and addressed in other writings), is that financial regulation is overly reactive to past crises. This article addresses a less obvious but arguably more fundamental flaw: that financial regulation is normally tethered to the financial architecture, including the distinctive design and structure of financial firms and markets, in place when the regulation is promulgated. In order to effectively address future crises, this article argues, financial regulation must transcend that time-bound architecture. This could be done by regulating the underlying economic functions of the financial system — the provision, allocation, and deployment of financial capital — as well as the financial system’s capacity to serve as a network within which those functions can be conducted. The article analyzes how to design and implement such a “functional” approach to financial regulation. Although this approach is primarily normative, it provides regulatory ordering principles that should have practical utility — not only as a set of standards to inform actual regulatory design but also as a counterweight to the prevailing view that macroprudential regulation of systemic risk can be adequately served by an ad hoc assortment of regulatory “tools.”

Keywords: financial systems, systemic risk, financial regulation