Regulatory Reform After the Crisis: Opportunities and Pitfalls

The recent crisis has led to a thriving academic and policy debate on the future regulation of financial institutions and markets. This paper argues that the objective of securing financial stability should be balanced with the goal of fostering financial deepening and efficiency, especially in emerging markets. This would require a market-harnessing rather than market-restricting approach to regulation; it would imply price-based capital and liquidity regulation, rather than restrictions and prohibitions; it would focus on forcing financial institutions to internalize the external costs of their risk-taking decisions rather than suppressing financial innovation. Beyond changes in the capital and liquidity requirements and corporate governance structures, the overhaul of failure resolution systems should top the reform agenda, to better address incentives problems and impose market discipline, even on large, too-important-to-close financial institutions. Reform areas should include both legal and regulatory frameworks and incentive structures for regulators and supervisors.