Regulating Finance: Balancing Freedom and Risk

Regulating Finance: Balancing Freedom and Risk

Regulating Finance: Balancing Freedom and Risk

Regulating Finance: Balancing Freedom and Risk


Grounding its analysis in the historical evolution of financial regulation, this book addresses a range of public policy issues that concern the design of financial regulation and its enforcement, and contributes several new ideas to the debate in this field. Financial systems have become morecompetitive across sectors of financial institutions and nations, and direct regulations have been removed in pursuit of efficiency. However, as the risk of institutional failures has increased, de-regulation has had to be followed by re-regulation. In which form should this happen? This bookanswers this question. First revisiting the issue of "why to regulate", Padoa-Schioppa argues that the need to continue to regulate banks in a special way follows from their key role as liquidity providers. At the same time, his argument recognizes the need for close interplay in the regulation of different financialsectors. The book goes on to discuss "how" regulation should be carried out in the modern environment. It should be market-friendly, but the balance between official intervention and market discipline is difficult to get right. Moreover, in an increasingly international context, financial regulationhas to be evenly applied across countries to avoid regulatory arbitrage. The final part of the book turns to issues specifically connected with developments in the European Union. One major issue is the maintenance of financial stability in the Euro area where the financial system is becoming especially integrated. Another major issue is the appropriate role of centralbanks. As the literature and practice are still very much under development, Padoa-Schioppa analyses the general aspects of the financial stability function of central banks -- particularly in relation to the monetary policy and supervision functions -- as well as the tools available for theEurosystem.


After decades of neglect, financial regulation and supervision have moved to the forefront of policy making. Practitioners, academics, officials and politicians have engaged in a public debate much in the same way as they did for monetary policy since the 1950s.

Several factors have contributed to the rise in interest in public policy aspects of financial activity. The first is the reappearance of financial instability. After many decades of tranquillity, a series of banking and financial crises have hit—from the 1980s onwards—a number of industrial and emerging economies as well as the global financial system. This called for extensive use of taxpayers' money and raised questions about the adequacy of the regulatory framework that had been designed in the aftermath of the financial crises of the 1930s.

A second factor is the phenomenal expansion of finance relative to the real economy, an expansion due to the rise in wealth, the widening split between savings and investment, the institutionalisation of saving, and the swelling of public sector deficits. The financial sector, which has traditionally been among those where public intervention was most pervasive, grew to such an extent that its regulation climbed to the top of political priorities.

A third factor were the advancements in technology, which made it possible to circumvent many regulatory barriers and segmentations erected to safeguard financial stability and reduce competition. Real time, remote, or intra-day finance and the development of trading outside formally organised markets have rapidly subverted the basis on which traditional regulatory instruments rested.

Financial innovation, partly driven by new technologies in the processing and transmission of information, was a fourth factor. A wave of new products, new market infrastructures, new trading and settlement systems, and new risk management practices completely transformed the financial industry. Regulation and supervision could not ignore the progressive blurring of the segmentation between the three traditional fields of finance: banking, securities, and insurance.

A fifth factor was the globalisation of finance, whereby financial transactions were less and less conducted in the closed world of nation states and increasingly implicated more than one country, one currency, one regulatory and legal system, and one supervisor.

A sixth and final factor was the change in the mission and institutional profile of central banks. Less than fifteen years ago, most central banks were still agencies charged with the defence of all public interests associated with the currency and the financial system, under rather strict dependence on the executive branch of the government. Since then, they have turned into independent institutions, strongly focused on the pursuit of price stability, and often deprived of the function of supervising and regulating banks.

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