On the Theoretical Foundations for Regulating Financial Markets

How we think about financial markets determines how we regulate them. Since the 1970s modern finance theory has shaped how we think about and regulate financial markets. It is based on the notion that markets are or can be made (more) efficient. Financial markets have been deregulated when they were thought to achieve efficient outcomes on their own; and regulation was designed to lend crutches to them when it appeared that they needed support. While modern finance theory has suffered some setbacks in the aftermath of the global crisis, defenders hold that improving market efficiency should still be the overriding concern for regulation. This essay raises the question whether this is indeed the case. What if other factors besides information costs affect the vulnerability of markets to crises? Two factors have been identified in the literature: Imperfect Knowledge and the Liquidity Constraint. This essay introduces the relevant theories that focus on these factors and discusses their regulatory implications