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Banking Regulation versus Securities Market Regulation

  • Franklin Allen
  • Richard Herring

There is a long tradition of regulating banks and securities markets in many countries. The primary justification for bank regulation that is usually given is the avoidance of systemic risk, or in other words, the avoidance of financial crises. With securities markets it is usually argued the main purposes of regulation are investor protection and enhancing the efficiency of markets. Avoidance of systemic risk, investor protection and efficiency enhancement are not the only rationales. The achievement of broader social objectives, such as combating organized crime or facilitating home ownership, provides the justification for many other regulations. Table 1 summarizes the role of different types of banking and securities market regulations in achieving the four objectives of avoiding systemic risk, protecting retail investors and depositors, enhancing efficiency and achieving broader social objectives. It can be seen from Panel A that although banking regulation primarily prevents systemic risk most policies also impact a number of the other objectives. From Panel B securities market regulation is directed towards investor protection and efficiency enhancement. In recent years the relationship between banking regulation and securities market regulation has become an important topic. Emerging markets have been plagued by crises. The recent Asian crises are a good example. Most of these crises occurred in bank based financial systems and the non-contingent nature of banks' liabilities appears to have played an important role in causing the crises. Banking regulation failed to prevent the occurrence of the crises. This has led a number of observers to argue that Asian countries should rely more heavily on financial markets for raising funds and reduce the role of banks. This raises the important question of whether securities market regulation would need to be changed to focus more on systemic risk. The purpose of this paper is to consider the inter-relationship of bank regulation and securities regulation in order to consider whether a move away from a bank-based financial system towards a market-based system is desirable in terms of crisis prevention. Section 2 considers banking regulation while Section 3 focuses on the regulation of securities markets. As has been stressed, banking regulation is primarily designed to prevent systemic risk while securities regulation is primarily for investor protection and efficiency enhancement. But this does not necessarily imply that a switch from banking to market finance would reduce systemic risk. Sophisticated financial markets require the participation of many intermediaries and systemic risk may be created if any of these go bankrupt and there is contagion to the rest of the financial system. Changing regulation to prevent this may not be very effective. Section 4 argues that a better way to prevent systemic risk if there is a move towards market finance and away from bank finance is to structure bankruptcy law appropriately. Section 5 contains concluding remarks.

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Paper provided by Wharton School Center for Financial Institutions, University of Pennsylvania in its series Center for Financial Institutions Working Papers with number 01-29.

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Date of creation: Jul 2001
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Handle: RePEc:wop:pennin:01-29
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