1 Financial Institutions, Markets and Regulation: A Survey Thorsten Beck, Elena Carletti and Itay Goldstein 1 1. Introduction The recent crisis has given impetus not only to an intensive regulatory reform debate, but to a deeper discussion on the role of financial systems in modern market economies and the role of financial innovation. While there has been an array of regulatory reforms, most of these reforms are aimed at avoiding the past crisis and are less forward looking than we would like them to be. This paper takes stock of the existing literature on market failures in the financial system and the consequent fragility risks, discusses possible policy responses and discusses new areas of research. It draws on a very rich theoretical and empirical literature, partly motivated and informed by the recent crises. However, the paper also takes a more principled stance on some of the challenges faced by policy makers and regulators. While we discuss the main market failures in banking and how the recent regulatory reform address them, we also note that financial innovation, the changing border between regulated and non-regulated institutions and increasing complexity makes the optimal regulatory framework a moving target. We conclude with a few main messages on regulatory reforms. While trying to flesh them out with some detail, we purposefully keep them on a more general level. Specifically, based on the discussion throughout the paper, we conclude that (i) a mix of complex and simple regulatory tools is needed, where the former reflects and influences market players’ risk -taking decisions, while the latter are less likely to be circumvented; (ii) macro-prudential has to complement micro-prudential regulation, as the stability of individual financial institutions does not add up to systemic stability; (iii) a stronger focus on effective resolution is necessary, not just to minimize the risk of contagion and reduce the impact of fragility on the real economy but also to set desirable incentives ex-ante for all the agents operating in the financial systems (institutions, investors and policy makers); and (iv) a dynamic approach to regulation is critical, especially when it comes to defining the regulatory perimeter. The remainder of the paper is structured as follows. The next section discusses market failures in the financial system that lead to fragility. Section 3 discusses regulatory responses to these market failures, while section 4 presents recent regulatory reforms in the wake of the Global Financial Crisis. Section 5 focuses on 1 Beck: Cass Business School, City University London and CEPR; Carletti: Bocconi University, CEPR and IGIER: Goldstein: University of Pennsylvania. We would like to thank Andrea Amato Marco Forletta for excellent research assistance.
2 the role of financial innovation both in deepening and completing financial markets but also creating financial fragility. Section 6 is concerned with the regulatory perimeter. Section 7 draws policy conclusions from our analysis, while section 8 concludes and looks forward to new research challenges.
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