Role of the state in financial markets

The paper begins by observing four salient aspects of capital markets. (1) Government interventions appear to be ubiquitous, even in highly developed financial markets, such as that of the United States. (2) There has been a long history of financial debacles, and there are large costs associated with these debacles. (3) In spite of the attention paid to the stock market, even in more advanced countries such as the United States, relatively little new investment is financed by the issuance of equities. (4) Many of the innovations in financial markets are not welfare enhancing; they can be viewed as rent seeking expenditures. The paper identifies 10 market failures associated with financial markets, most of which are related to problems of imperfect and costly information. The paper describes government interventions, many of them in the form of regulations, directed at six objectives related to underlying market failures: (1) protecting consumers; (2) enhancing the solvency of banks; (3) ensuring competition; (4) directing resource allocation; (5) enhancing macroeconomic stability; and (6) stimulating growth. The paper proceeds to derive a set of principles which should govern these regulations, emphasizing the limitations of the regulators" enforcement capacity (which must often rely on indirect rather than direct control) and information sources, as well as the importance of providing the regulated with incentives to behave in a desired way. These general principles are illustrated through an analysis of the design of bank prudential standards. The Savings and Loan debacle in the United States is attributed, in part, to the failure to design appropriate prudential standards, this contrary to much popular discussion, which has placed the blame either on incompetent regulators or deposit insurance. The report argues that the two major principles of sound prudential regulation are: (1) maintaining high net worth and capital requirements; and (2) restricting the interest rates paid on insurance deposits. (Author abstract, modified)