Fundamental principles of financial regulation and supervision

The financial system is a private-public partnership coming from government ceding the right to produce means of payment with the related permission on leveraged lending services, against the acceptance of rules designed to ensure stability for both individual institutions and the financial system. The experience shows that market-based regulation does not produce the wanted results, while rules-based and principle-based regulatory systems are prone to regulatory avoidance and capture, especially with complex regulatory schemes. While the reaction to the recent crisis has prompted a wide range of financial reforms, in a duel to match complexity with complexity, the previous approach based on leaving market forces to mould the financial structure with few if any constraints maintained. The paper shows that this approach adopts faulty or casuistic policy implications derived from both the laissez faire and the second-best versions of mainstream economic theory. However, some of its basic features, such as regulating institutions and products and not functions, and as promoting the international level playing field, are not coherent with its reputed theoretical foundations. Furthermore, the absence of strong principles and the impossibility to derive conclusive quantitative proposals from cost-benefit evaluations leaves an unacceptably wide area of discretion for experimentation with trial and error processes, easily leading to weak or distorted regulation. The difficulties experienced within this framework to deal with problems such as those posed by systemic institutions, shadow banking, weak rules and supervision, distorted risk evaluation, high compliance costs, etc. has convinced some observers that a ‘revolution’ in economic thinking and policy is required. Following Minsky, the conclusions review a heterodox approach to financial fragility and regulation. Characterising banking in terms of liquidity creation through acceptance, and distinguishing it from the production of liquidity by other financial institutions, it concludes that financial organisations should be regulated according to their function in providing liquidity of different types to the financial system.