Global financial markets are currently perceived to be in crisis. Debate over regulatory reform in the financial industry has, consequently, assumed national prominence. Although many American industries are heavily regulated, including public utilities, telecommunications, and transportation, the financial industry arguably exhibits the most complex system of regulation in this country. This complexity is exacerbated by recent technological changes within the banking industry, as well as by the effects of these changes on the competitive structure of domestic banking and other financial markets.
Institutionalists have traditionally argued for government intervention when the market fails to produce a socially desirable outcome. While we do not deny these arguments, we would also suggest that the technological change inherent in a financial innovation may in fact promote a progressive institutional change that enhances social welfare. The problems of inefficiency or inequity in the financial sector may, consequently, be ameliorated by technological change. This implies that government regulatory intervention may not always be necessary in the event of a failure of the market to provide an optimum outcome.
Financial Governance and Regulation
Governance is that broad field of economics which concerns the design of institutions through which exchange is conducted. The economic theory of regulation, a subfield of governance, most often examines how collective action by individuals, through the auspices of government, affects the incentives of participants in private markets. The theory of governance, an area of commonality between certain aspects of institutional and neoclassical economics, also examines how economic institutions evolve, both through technological innovations and through bargaining between coalitions of individuals whose welfare depends on the pattern of trade within these institutions. Regulation of financial markets is best examined within this context.
Institutional structure, which includes legal restrictions, traditional practices, and regulatory policy, constitutes the technology of exchange. Alternative structures may, at any particular time, vary widely in terms of their economic efficiency. Neoclassical economists normally use the criterion of allocational efficiency, or related concepts such as constrained allocational efficiency or relative efficiency, to assess the performance of a set of market institutions. The neoclassical approach to regulation focuses on market failure and the role of government in mitigating such failures or, in the absence of inefficiencies, the design of least-cost methods of redistributing income or, alternatively, on an interest-group theory of government intervention to promote such redistribution (Trebing 1987, 1716).
The institutional approach to regulation more explicitly considers broader issues of governance and institutions as the technology of exchange. The basic postulates of the institutionalist approach to regulation are as follows:
* The need for government intervention exists because industrialized societies give rise to concentration of power, increased uncertainty, performance failures, uncompensated costs, and adverse distributional effects.
* Regulation must endeavor to promote public interest or social values that cannot be derived exclusively from monetary or market-oriented measures.
* When properly applied, regulation seeks to promote higher levels of efficiency and greater individual choice. Regulation can convert emergent values into allocative decisions that better reflect social wants.
* Strategies of actors in the regulatory process can have a significant impact on the outcome.
* Since the evolutionary process makes any set of goals and methods provisional and intermediary, it follows that the form of regulatory intervention may change over time (Trebing 1987, 1714-1715).
The twin objectives of efficiency and equity may, however, often be mutually incompatible in practice. The traditional neoclassical theory of regulation focuses on how these objectives can be attained through government intervention, and much of that theory involves an examination of the relative costs of the state pursuing such goals. The choice of policy instruments is directly related to the choice of regulatory objectives and involves the means by which the incentives of individual market participants are influenced by government in order to achieve specific goals. These means can range from direct legal edicts or command and control procedures to broad regulations incorporating a role for market incentives.
Institutional structures may adapt to resolve or mitigate existing sources of inefficiency or distributional inequity. One means of such adaptation, compatible with the traditional neoclassical approach, is through collective choice in the form of the direct and active regulation of exchange by government. A second means, largely unrecognized in the neoclassical approach to regulation but consistent with institutional theory of Clarence Ayres, involves the response of existing institutions to private innovations in new technologies and products and the resulting creation of new markets. This is most frequently accomplished, in the case of financial institutions, through innovations in contracts, in arrangements for the securing of tangible and intangible collateral, and in the creation of new assets such as various forms of derivative securities, including options, swaps, and forward and futures contracts.
If active intervention in financial markets is pursued through the adoption of any particular regulatory initiative, policy makers must be aware that adoption of the regulatory initiative imposes costs, as well as potential benefits, to all members of society. Regulatory policies designed to enhance the efficiency of private markets must be able not only to fully or partially resolve the cause of existing inefficiencies but also implementable at a cost sufficiently low as to allow the economy to enjoy a net benefit from the adoption of the policy.
Institutional Evolution, Financial Innovation, and Regulation
The loss of wealth owing to pervasive inefficiencies in an existing institutional structure governing financial exchange may cause that structure to change in order to mitigate such a loss. The most analyzed source of such change is through collective choice, in the form of direct intervention in financial markets by the government. As a means of implementing the collective choice of market participants, government uniquely possesses the advantage of legal coercion.
The state also shares several disadvantages with private market participants, such as the costs of monitoring disclosure and compliance. Most important, however, the state exhibits two unique liabilities through its role in enforcing private contracts. First, through its selection of a regulatory policy governing legal exchange, it provides a comprehensive set of incentives which universally affect all other market participants. Second, by its role as the means of implementing collective choice, the state cannot credibly commit to certain types of regulatory strategies.
Alternatively, one may consider the scope for endogenous evolution in existing institutions through the response of those institutions to the reductions in transactions costs made possible by technological advance, which, in turn, leads to a greater frequency of private innovation in products and the resulting creation of new markets. The creation of new financial assets, including various types of options, increasing securitization of bank loans, and the creation of new markets for private debt, all increase the ability of individuals and intermediaries to manage risk through private exchange.
Such innovation is the natural result of competition for the potential economic profits (rents) implicit in the resolution of market failures and may endogenously induce greater efficiency of existing institutional arrangements in the performance of the financial functions which must be fulfilled in every economy. As Paul Dale Bush noted, "The technological process is inherently dynamic. Technological innovation creates new possibilities for inquiry and problem-solving.... [T]echnological innovation involves a change in behavior, and changes in behavior create new problems for the community in the correlation of behavior"( 1987, 1089).
Endogenous adaptation of financial institutions in the absence of active regulatory restrictions can also reduce systemic risk, the default risk associated with contagious insolvency among numerous intermediaries participating in the payments system. Restrictions on entry into financial markets by potential lenders and intermediaries, as part of conventional regulatory policies, discourages diversification in the supply of financial securities.
The resulting market concentration nor only decreases economic efficiency through imperfect competition but also exacerbates any systemic risk that might arise from insolvency or illiquidity among the incumbent intermediaries. If the opportunities to exchange financial assets can be diversified among many independent market participants, then the scope for systemic failures in the financial system is minimized. Unanticipated financial distress may still inflict losses upon individuals directly involved in a specific exchange, but potential externalities, whether these are real or pecuniary, to the economy are reduced as the number of independent buyers and sellers of such financial contracts increases.
What we are suggesting is that the financial innovations may in fact promote progressive institutional change. According to Bush, "'Progressive' institutional change occurs when, for a given fund of knowledge, ceremonial patterns of behavior are displaced by instrumental patterns of behavior" (1987, 1101). Though, as Bush noted, this progressive institutional change is limited by (1) the availability of knowledge, (2) the capacity for understanding an adaptation, and (3) the principle of minimum dislocation (1987, 1105; also see Minsky 1996, 359, and Minsky 1957).
Efficient Roles for Regulatory Supervision
The role of government in financial markets must be to contribute to the development of an efficient system for financial governance, which includes the organization of a reliable payments system and clearing mechanism, standardized accounting procedures, and a uniform legal code through which financial contracts can be enforced. Appropriate public policy involves measures which insure that these market incentives are indeed operative and, mast particularly, that information germane to financial exchange is produced and disseminated to the most efficient possible degree.
One role for government in establishing an efficient structure for public financial governance involves the standardization and refinement of techniques for financial accounting. Conventional or generalized accounting procedures are static in nature, focusing on realized values of elements of the random income streams comprising most marketable financial assets (see Merton 1989 and Merton and Bodie 1995).
A second role for government lies in reducing transactions costs in financial markets and most especially the costs of enforcing financial contracts. These costs, such as those involved in lending, may be relatively high owing to both legal restrictions on lenders taking contingent positions in the investments of their borrowers (banks, for example, are limited in holding equity positions in firms which borrow from them) and on the legal costs associated with the liquidation of collateral assets in the event of borrower default (see Jones and Nickerson 1998).
The government should also seek to ensure the continuous disclosure of portfolio holdings by intermediaries. By creating the opportunity for competing intermediaries to credibly commit to such strategic disclosure, in the context of an imperfectly competitive credit marker, internalities will be reduced and incentives for prudent financial management enhanced. The disclosure of information relevant to private financial exchange, which also includes the trading strategies of the central bank (Federal Reserve) and fiscal budgeting of government agencies, such as the SBA in the United States, active in private credit markets, can help coordinate investment planning among private individuals and firms in the nascent or thin domestic credit markets, such as those for community-based lending.
Another role for government involves measures to mitigate the adverse incentive effects created by its inability to credibly refrain from offering loan guarantees which insure the debt of large and politically influential intermediaries. Traditional regulatory methods involve restricting the strategies available to such intermediaries by (1) imposing capital adequacy requirements, (2) restricting ownership between intermediaries and certain classes of borrowers, such as manufacturing firms, and (3) imposing restrictions on yields paid on the deposit liabilities of these intermediaries. These measures are intended to inhibit the incentives that bank managers have to increase the volatility of earnings, by insuring that equity holders in any financial institution have an appreciable portion of their own wealth exposed to the risk of insolvency, rather than relying primarily on that of depositors or, through mispriced government loan guarantees, that of the general public.
A final role for the government in emerging economies is to address the difficulties posed to uninformed or neophyte traders by their participation in private financial markets. Incentives, possibly including subsidized educational programs, could be offered to such traders to acquire and maintain sufficient expertise to infer and evaluate the risks they are facing.
Institutional structure, which includes legal restrictions on markets, traditional practices, and regulatory policy, constitutes the technology of exchange. Within alternative institutions or technologies, markets may vary in terms of both their efficiency and equity, and neoclassical and institutional economists have approached the regulation of such markets from different perspectives. When they admit to market failure, neoclassical economists examine a narrow scope for government intervention, examining how regulations can influence individual incentives to replicate the allocation that would be achieved if markets were efficient. Institutionalists consider a broader role for government intervention, most often on the basis of promoting welfare through redistribution, in which governments change, through collective action, the institutional structure in which markets are embedded.
The traditional approaches of neoclassical and institutional economists to the regulation 'of markets, however, both share a fundamental reliance on the role of the state in influencing the evolution of institutions governing exchange. Consistent with earlier institutional research (Thorstein Veblen, Clarence Ayres, David Hamilton), we suggest a third means by which institutional structures evolve to reduce market inefficiencies and inequities: endogenous technological innovation, which occurs in response to foregone social wealth inherent in market inefficiencies, Such innovations, especially prevalent in financial markets during the last ten years, are a form of "progressive technological change" that can enhance efficiency. Recognition of endogenous technological innovation is not a naive reliance on market forces, however; rather it is the recognition that technological change creates new institutions that may improve efficiency or equity. This is, however, not to say that this always occurs, and a fruitf ul direction for future research is to determine necessary and sufficient conditions for endogenous technological innovation to enhance efficiency.
While these private innovations may enhance economic efficiency in the absence of suboptimal regulatory policies, the presence of distortions from such policies can create incentives for efficiency-reducing innovations in the private sector.
Given the current state of knowledge about financial markets, as well as the obvious difficulties in devising and implementing an effective policy of monitoring and enforcing compliance, the social costs posed by refining traditional forms of financial regulations, such as capital requirements, may exceed the benefits to such refinement, Vital directions for future theoretical and empirical research into efficient financial governance must focus on both the costs of implementing financial regulations and the capacity for the endogenous resolution of extant inefficiencies by private financial institutions through the process of financial innovation.
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Jones, Robert A., and David Nickerson. "Debt Contracts, Stochastic Collateral, and Credit Rationing in Emerging Financial Markets." Working paper, The American University Department of Economics, Washington, D.C., November 1998.
Merton, Robert C. "On the Application of the Continuous-Time Theory of Finance to Financial Intermediation and Insurance." Geneva Papers on Risk and Insurance 14 (1989): 225-62.
Merton, Robert C., and Zvi Bodie. The Global Financial System: A Functional Perspective Cambridge, Mass.: Harvard University Press, 1995.
Minsky, Hyman P. "Central Banking and Money Market Changes." The Quarterly Journal of Economics 71, no. 2 (1957): 17 1-187.
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The authors are Professors in the Economics Department, Colorado State University. This paper was presented at the annual meetings of the Association for Evolutionary Economics, Washington, D.C., January 3-5, 2003.…