Why do we regulate finance?

March 8, 2025

We need financial regulations. But why do we regulate, and do we get what we want out of them?

Finance has always been heavily regulated, long before other forms of regulation.

Regulations have often been draconian. In the 13th century, Barcelona was a major financial centre with strict financial controls. Banks were required to maintain substantial capital and pay depositors within 24 hours of demand. Failure to do so carried severe consequences — not just in the eyes of the almighty, but also with city authorities.

In 1360, Francesc Castells was beheaded in front of his bank for failing to repay depositors. Yet, even the threat of execution did not deter his fellow bankers from misbehaving.

Why do we regulate today? For the same reasons as 13th-century Barcelona: to protect consumers, prevent crises, and ensure stability. Without regulation, financial markets could resemble the Wild West — rife with abuse and a drag on economic activity.

The intensity of regulation ebbs and flows. Tighter restrictions often follow periods of deregulation in response to the next crisis or scandal.

After every crisis, the tendency is to raise capital and liquidity buffers. Still, crises do not stop coming. The case of Francesch Castello suggests why.

As regulations tighten, they become increasingly politicised, triggering backlash and much-needed corrective action.

I contend that we have lost sight of the true objectives of financial regulation, focusing on compliance and de-risking rather than what truly matters.

Instead, the objectives of regulations is to help maximise economic growth subject to subject to us not suffering too many costly crises and abuse of clients.

$$\max \frac{\text{ Growth}}{\text{Undesirable outcomes}}$$

We are not doing this joint socially constrained optimisation, merely focusing on the denominator.

Not only does this move us away from the optimal outcome, but paradoxically, it is counterproductive, increasing risk. There are at least two reasons for this.

First, the financial system is infinitely complex, and no matter how vigilant the supervisors are, they can only patrol a small portion of it. In practice, when they contain one source of instability, it may well resurface elsewhere, beyond their watch. In such a complex system, opportunities for instability are always present. It is almost axiomatic that crises occur where authorities are not looking.

Second, if authorities are seen as overly vigilant, they risk political backlash from lawmakers who ultimately have the power to overrule them. While much attention is given to the U.S. under Trump, a similar situation is unfolding in Sweden, where Parliament is relaxing real estate-based macroprudential constraints against the regulator's wishes. The British government is complaining about regulations holding back growth.

Given that regulations are increasingly onerous and ineffective, I welcome political leaders on both sides of the Atlantic voicing concerns about their impact on economic growth.

The stricter the regulations, the higher the cost of financial intermediation — ultimately borne by the financial system's clients.

In a bank-based economy like Europe, this significantly hampers economic growth and contributes to secular stagnation.

It would be far better if the authorities were given a clear growth mandate and encouraged to promote non-bank financial intermediation.

A win-win-win not The Illusion of Control.

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