Modern Financial Systems: Theory and Applications

CHAPTER 22

Financial Regulation

This chapter considers how regulation can help enhance financial system performance. The discussion begins by considering regulatory principles, the effectiveness of regulatory policy, and the approaches regulation can take. The next section compares and contrasts regulation of different institutions and markets, both domestic and international. In the last section, it considers how the market turmoil of 2007-2008 has stimulated recent corrective measures and proposals for future regulatory action.³⁹²

AIMS AND APPROACHES

Although regulation is aimed at improving system performance, its benefits are very often sought through imposing either restrictions or reporting requirements. These kinds of regulatory actions can both increase the cost of doing business and in some cases stifle innovation. At the same time, if regulation limits profitable business activity, a substantial proportion of managerial effort will likely be devoted to finding ways of avoiding the restrictions, frequently through innovation. Thus in at least some instances regulators face a choice of either trying to guide private sector initiatives or of restricting private sector initiatives and then attempting to deal with innovations aimed at avoiding the restrictions. In addition, successful innovations can create their own difficulties, such as the lowered lending and investment standards accompanying asset price bubbles. Regulators usually respond to such emerging difficulties ...