New Economics of Regulation: Financial Stability as a Social Dilemma

This article is an exploratory essay on financial regulation and stability in the light of the 2007-2008 turmoil. It seeks to bring forth the major characteristics of the regulatory environment that let the crisis dynamics develop in spite of numerous warning signs that became apparent from the years 2005. In this vein, I draw upon the New Economics of Regulation (Laffont, 1994).I then suggest a non-cooperative communication game between an extra-market (a public) regulator and the market players (the regulatees) and study the rules that could lead to a relevant incentives mechanism. These rules should perform in their communication and coordination role by allowing financial institutions to undertake activities that are consistent with systemic stability. Compared with the literature developed on this issue, the article offers an alternative perspective to financial stability. It assumes that systemic stability is a public good that decentralized market mechanisms cannot provide. I borrow from the analysis of Ostrom (1998) on the commons and collective action and argue that financial regulation takes on systemic importance since a smooth functioning of markets requires continuous and sustainable provision of financial stability. The implementation of the model rests on a comparison between two alternative communication processes: a binding mediation-based revelation model and a low-constraints-based cheap talk process. The optimal framework is a function of a given environment. Each alternative reveals to be relevant only under a set of specific conditions. The relevance of a regulatory framework then rests on the consistency of an institutional environment with regard to the institutional characteristics of the economy. A possible implementation of the results can be considered in all areas of public choice that partially involve market mechanisms and that have to face coordination problems in order to respond to societal shocks such as the current Covid pandemic.