Regulating the financial markets and institutions - who, how and why?

Financial regulation is needed because of the market imperfections arising from asymmetric information and systemic risk, and three key developments in the financial sector over the last 40 years: globalisation, the emergence of financial conglomerates that combine traditional banking and investment banking, and financial innovation leading to the development of complex derivative products. These factors imply that financial regulation should be designed so that it: penalizes bank size by making capital requirements and liquidity requirements depend on bank size; makes capital and liquidity requirements countercyclical; separates investment banking and commercial banking activities; imposes the same set of regulations for all financial institutions, including hedge funds, special-investment vehicles, and private-equity funds; regulates all markets for systemically important financial instruments and infrastructure; regulates innovation in financial products; and, monitors monetary policy and leverage to limit cheap credit.

In implementing these policies, it is important to recognize that regulation has significant costs, both in terms of implementation and also in terms of dealing with the economic uncertainty arising from changes in regulation. Given these costs, the appropriate approach should be to reduce financial regulation to the optimal level, and to undertake measures that enhance the functioning of markets by directly addressing existing market imperfections.