The Accelerating Integration of Banks and Markets and its Implications for Regulation

Abstract

The banking landscape is in flux. Financial institutions and markets have become deeply intertwined and competitive pressures have intensified. Stability issues have become paramount, aptly illustrated by the credit crisis of 2007-2009. In this paper we review the existing literature to analyze the various implications of these developments and what they portend for bank regulation. We begin by discussing the economics of banking to better understand the fundamental forces driving the financial services industry. We discuss how banks choose between relationship and transaction lending, the role of debt versus equity instruments, and the economic functions of banks. We conclude that banks and markets have become increasingly integrated and co-dependent, and that this is at the root of the 2007-2009 credit crisis. In this context, we also focus on credit rating agencies and new intermediaries like private equity firms, which one could interpret as intermediation driven from the equity side, and examine their impact on financial fragility. We address the regulatory challenge coming from financial fragility, and focus on this in the context of the “mushrooming” of the financial sector with greater diversity in institutions and an increasingly blurred distinction between intermediaries and financial markets.