Abstract: This paper is one chapter of the volume “Regulation and Economics” of the second edition of the Encyclopedia of Law and Economics. The authors review the economics of banking and financial markets and the regulatory response to market failure. Market failure in finance depends on problems of information and externalities. Regulation addresses these problems through conduct of business rules and prudential requirements. This approach has recently proved insufficient to prevent financial crises. Governments and central banks had to step in with massive safety nets in order to prevent financial meltdown. Although the appropriate regulatory response to the global financial crisis is still to be discovered, this chapter tries to draw a few lessons for financial regulation and supervision. First, prudential regulation and supervision should monitor, and possibly limit, competition between banks and non-banks in order to identify timely new sources of systemic risk. Second, financial stability policies need to strike a difficult balance between ex-ante strictness and ex-post leniency in order to deal with non-quantifiable risks. Moral hazard is not the only determinants of systemic instability; knightian uncertainty also determines instability by suddenly curtailing market and funding liquidity. Third, all financial institutions falling within the regulatory perimeter should have good corporate governance. However, what is good governance for non-financial firms is not necessarily efficient for financial firms due to the quality and quantity of externalities involved. Finally, because systemic externalities are cross-jurisdictional in modern financial markets, at least coordination among monetary and supervisory authorities of different countries is warranted.

Additional Metadata
Keywords Banking, Corporate Governance, Financial Crisis, Financial Markets, Information, Insurance, Liquidity, Moral Hazard, Regulation, Uncertainty
JEL Financial Crises (jel G01), Government Policy and Regulation (jel G28), Regulation and Business Law: General (jel K20), Regulated Industries and Administrative Law (jel K23)
Persistent URL hdl.handle.net/1765/34943
Note RILE Working Paper Series No. 2011/04. Also a chapter in: Regulation and Economics: Second Edition Encyclopedia of Law and Economics, Alessio M. Pacces, Roger J. Van den Berg, eds., Cheltenham: E. Elgar, 2012
Pacces, A.M, & Heremans, D. (2011). Regulation of Banking and Financial Markets. Retrieved from http://hdl.handle.net/1765/34943