Regulating Financial Markets: Assessing Neoclassical and Institutional Approaches

By Nickerson, David; Phillips, Ronnie J. | Journal of Economic Issues, June 2003 | Go to article overview

Regulating Financial Markets: Assessing Neoclassical and Institutional Approaches


Nickerson, David, Phillips, Ronnie J., Journal of Economic Issues


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). …

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