Regulation of banking and banks governance: When liquidity drives financial behaviour

This paper presents a dynamic approach to liquidity based on uncertainty as conceptualised by Knight, developed in a theory of long-term expectations by Keynes, and applied to banking by Minsky. This perspective reveals that banks perform maturity transformation and create monetary liabilities by overcoming uncertainty about the future based on generally accepted conventions of safety. When uncertainty returns to the forefront, acceptance of private money is compromised and a liquidity crisis may ensue. On this basis, the paper illustrates how banking should be regulated ex-ante and supported ex-post by central banks in order to reduce financial instability. Regulation and the safety net should be complemented by corporate governance committing bank managers to long-term horizons. Rules on managerial remuneration are insufficient for this purpose. Insulating bankers from market pressure for highrisk, high-returns strategies should be allowed too. Copyright

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