What Is Optimal Financial Regulation?

Abstract

The financial system is regulated to achieve a wide variety of purposes. However, the objective that distinguishes financial regulation from other kinds is that of safeguarding the economy against systemic risk. Concerns regarding systemic risk focus largely on banks, which traditionally have been considered to have a special role in the economy. The safety nets that have been rigged to protect banks from systemic risk have succeeded in preventing banking panics, but at the cost of distorting incentives for risk taking. Regulators have a variety of options to correct this distortion, but none can be relied upon to produce an optimal solution. Technological and conceptual advances may be ameliorating the problem, nonetheless. Banks are becoming less special. The US is leading the way, but the trends are apparent in other industrial countries as well. The challenge facing regulators is to facilitate these advances and hasten the end of the special status of banks. Once banks have lost their special status, financial safety nets may be dismantled thus ending the distortions they create. Ultimately, regulation for prudential purposes may be completely unnecessary. The optimal regulation for safety and soundness purposes may be no regulation at all.