European Financial Integration: A Framework for Policy Analysis

In this paper, we investigate the design and implementation of financial regulation where market failures are created by asymmetric information between investors and firms. We argue that reputation, while providing some correction for imperfect information, should be supplemented by financial regulation. We focus on two regulatory tools: direct penalties and capital requirements (where capital includes all assets that can be appropriated by the regulators and those whose value is extinguished in case of revealed misconduct). We find that capital requirements have an advantage over penalties when there is a relation between firms' quality and their capital. Capital requirements will, however, be more onerous where there is a close relation between capital and quality and when there is less precision in imposing penalties.Next, we analyse whether self-regulatory organizations have adequate incentives to implement regulation. We find that such incentives do exist when firms have sufficient capital at stake, for example in the form of industry-specific assets, and where the benefits from cheating are limited.