The Banking Regulatory Bubble and How to Get Out of It

Abstract

We claim that we currently live in a banking regulatory bubble. We review how: i) banking intermediation theory hinges on dealing with borrower-lender asymmetry of information; ii) instead, the presence of complete information is the keystone of the finance theory. Next, we document how finance theory prevailed over banking intermediation theory in shaping banking regulation: This appalling contradiction is the true culprit behind lower credit standards, mounting systemic risk in banking, and macroeconomic debt overhang. Consequently, we discuss actions that, by restoring the consistency of banking regulation with the theory of banking intermediation, would make banking sounder.

Keywords: Asymmetric Information, Relationship Lending vs Transactional Lending, Efficient Markets Hypothesis, Banking Regulation Inconsistencies, Basel II

JEL Classification: G01, G14, G21, G28