Regulation of Banks and Finance

As in previous crises, there is an ambitious, extensive, and heavy agenda of regulatory reform in parliaments, research circles, and government agencies. This book provides a comprehensive review of the analysis of finance, economics, and the law and economics that illuminates the past and current banking and financial regulations designed to prevent events such as the credit/dollar crisis and the global recession. The regulation of financial institutions and markets has occurred during financial crises and recessions. There is no theory and experience of financial regulation carefully applied to the credit/dollar crisis that orients parliaments and government agencies in designing new measures or changes in existing ones. The rush to regulation is largely motivated ad hoc by the existing official interpretation of what caused the financial crisis and what measures are required for its prevention. Academic and policy research typically follows regulation in an effort to provide rigorous analysis of policy and its effects on the functioning of the financial system.

The objective of this chapter is to provide a general view of the theories of regulation followed by a final section on the role of finance in promoting efficiency and growth. The two main approaches are the public interest view, with emphasis on the need of government intervention to attain welfare improvements, and the private interest view, raising doubts about the effectiveness of regulation. The general theory of second best raises doubts as to the feasibility of determining welfare improving policies once the assumptions of the first best are violated. Applied welfare economics provides an engine for searching concrete information that could be useful in guiding policy. Property rights, transaction costs, and the new institutional economics (NIE) have changed the view of government intervention in markets. Asymmetry of information is an extremely important friction of the first best in financial markets. The capture theory has been modified by the analysis of the principal/ agent problem and the assumption of imperfect information. The final section considers finance, efficiency, and growth. There is a summary of the main themes in the chapter.

This chapter provides the analysis of the functions of deposit banks and two important types of regulation on required capital and deposit insurance. There is a preliminary section on the arguments in favor and against regulation. Chapter 3 covers the remaining types of regulation of deposit banks, which are market power and prudential supervision.

This chapter provides the analysis of two areas of significant regulation of banks. First, there are multiple mechanisms to restrict market power in banks. The main topics covered in various sections are market structure, entry, and market power. Second, government intervention in banking is proposed for stabilization of the economy. The main topics covered are the general principles of central banking, the transmission of monetary policy, inflation targeting, and the Lucas Critique and consistency of optimal plans. The text is completed with a brief summary.

This chapter and the following deal with the issues of regulation of financial institutions engaged in transactions with securities. The first section of this chapter considers the market structure of banking in relation to securities: universal, conglomeration, or specialized. The Glass-Steagall Act constitutes regulation during difficult times. Underwriting and loan syndications are important activities of investment banking. Governance is critical to the protection of rights of stakeholders in corporations. Mergers and acquisition raise intriguing issues of entry, corporate law, and takeover defenses.

This chapter covers the regulation of securities. The first section focuses on the need for companies to exit segments of activity or even for entire companies to exit in response to technological change. LBOs have provoked significant interest in the law and economics. The approaches of the United States based on rulemaking by the SEC and self-regulatory organizations (SRO) and the light touch of the United Kingdom are contrasted briefly in a separate section. The two following sections consider the regulation of new issues and insider trading. The last remaining sections cover the decision of going public, SOX, and listing of securities. There is a final brief summary.

The global recession is causing output contraction and unemployment in advanced countries, sharp reduction of growth in emerging and developing countries, and contraction of world trade in goods and services. The impact on output and employment is minute compared with the Great Depression of the 1930s. There is a section reviewing the literature on the Great Depression because of the significant rise of regulation and the constant reference to current events and policies. The origins of the credit crisis are critical in evaluating regulatory proposals. Monetary and fiscal policies in the current crisis are more aggressive than even during the Great Depression. The regulatory agenda is highly ambitious.

There are two main views on the origin of the credit/dollar crisis and the new measures for regulatory reform. The first view is based on the public interest or official regulatory view proposing tight regulation to avoid financial instability and resulting loss of output and employment. The second view is based on the finance view or FSF approach (Black 1993; Black, Miller, and Posner 1978; Levine 2002; Merton and Bodie 1995, 2005). These two approaches are discussed in turn.