The Role and the Future of Regulation in the Financial Crisis: The Uncertainty Perspective

Abstract

This paper analyzes the last financial crisis in the perspective of financial innovation focussing on the dynamics of systemic externalities in banking. After discussing the peculiar nature of banking and its external effects to society, it shows that one major determinant of the financial crisis was the failure of regulation to address the evolution of financial intermediation under uncertainty. Differently from the standard explanations, which are variously based on unanticipated opportunism and/or irrationality of financial intermediaries, this analysis suggests that regulation has not been insufficient. On the contrary, regulation has been so overly demanding towards traditional banking to promote unregulated forms of financial intermediation, thereby exacerbating the externalities of financial innovation. In contrast to the initiatives of regulatory reform on both sides of the Atlantic, which address the accidental aspects of the last financial crisis, this paper contends that the overhaul of financial regulation should focus on the general problem of banks’ dealing with uncertainty. As uncertainty makes externalities in banking most dangerous, this approach could fare better in preventing the next crisis. Three major implications are derived from this analysis. First, regulation should avoid inducing banks to make leveraged bets on new forms of short-term funding in order to compete with unregulated intermediaries. The latter should be prevented from engaging in the functional core of banking, maturity transformation, which is the recurrent source of systemic externalities. Second, in relying upon ratings, regulation should correct the incentives it provides to rating agencies to inflate their grades by making them liable for rating intractable uncertainties instead of measurable risks. Finally, regulation should avoid tampering with the corporate governance of banks. Allowing bank managers to protect their autonomy via contractual choices is a more promising solution to short-termism in carrying out financial innovation than regulation of bankers’ pay.