For the most part, the development of financial regulation has been an empirical process, a matter of trial and error, driven by the exigencies of history rather than by formal theory. An episode that illustrates the character of this process is the Great Depression in the US. The financial collapse in the US was widespread and deeply disruptive. It led to substantial changes in the laws regulating the financial system, many of which shape our current regulatory framework. The SEC was established to regulate financial markets. Investment and commercial banking were segregated by the Glass-Steagall Act (subsequently repealed and replaced by the Gramm-Leach-Bliley Act of 1999). The Federal Reserve Board revised its operating procedures in the light of its failure to prevent the financial collapse. The FDIC and FSLIC were set up to provide deposit insurance to banks and savings and loan institutions.
Looking back, there is no sign of formal theory guiding these changes. Everyone seems to have agreed the experience of the Great Depression was terrible; so terrible that it must never be allowed to happen again. According to this mind set, the financial system is fragile and the purpose of prudential regulation is to prevent financial crisis at all costs. Why does the mind set of the 1930's continue to influence thinking about policy? What does policy making continue to be an empirical exercise, with little attention to the role of theory? This empirical procedure is unusual. Indeed, the area of financial regulation is somewhat unique in the extent to which the empirical developments have so far outstripped theory. In most areas of economics, when regulation becomes an issue, economists have tried to identify some specific market failure that justifies the proposed intervention. Sometimes they have gone further and have derived the optimal form of regulation. This has not been the usual procedure with financial regulation, however.
The purpose of this chapter is to show how the framework developed in Chapter 6 can be used as the basis for analyzing optimal regulation. The widespread perception that financial systems are [fragile,] together with many historical episodes of financial instability, has created a presumption that regulation is required to prevent costly financial crises. In the previous chapter we argued to the contrary that, under conditions analogous to the assumptions