The Interplay among Financial Regulations, Resilience, and Growth

Interconnectedness has been an important source of market failures, leading to the recent financial crisis. Large financial institutions tend to have similar exposures and thus exert externalities on each other through various mechanisms. Regulators have responded by putting in place more regulations with many layers of regulatory complexity, leading to ambiguity and market manipulation. Mispricing risk in complex models and the arbitrage opportunities through the regulatory loopholes have provided incentives for certain activities to be more concentrated in the regulated entities and for other activities to leave the banking into new shadow banking areas. How can we design an effective regulatory framework that would perfectly rule out bank runs and TBTF and to do so without introducing incentives for financial firms to take excessive risk? It is important for financial regulations to be coordinated across regulatory entities and jurisdictions and for financial regulations to be forward looking, rather than aiming to address problems of the past.