Financial innovations, crises and regulation: some assessments

FINANCIAL INNOVATIONS, CRISES AND REGULATION: SOMEASSESSMENTS Francisco Pinto et Rogério Sobreira De Boeck Supérieur | Journal of Innovation Economics & Management 2010/2 - n° 6pages 9 à 23

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n° 6 – Journal of Innovation Economics 2010/2 9

FINANCIAL INNOVATIONS,CRISES AND REGULATION:

SOME ASSESSMENTSFrancisco PINTO

Secretary of Planning and Management of the State Governmentof Rio de Janeiro, Brazil

Financial System Study Group, Brazilian School of Publicand Business Administration,

Getulio Vargas Foundation (EBAPE/FGV), [email protected]

Rogério SOBREIRABrazilian School of Public and Business Administration

Getulio Vargas Foundation (EBAPE/FGV) and CNPq Researcher, [email protected]

The banking industry, as is well known, differs substantially from non-financial industries. Banks are agents operating in a system that is undoubtedlyone of the most sensitive sectors of the economy. It is an environment whereall economic agents interact through a dependency relationship, where thesavings of one are the investment of another. It is a segment where the finan-cial relationships between the members of a society are crystallized.

Directing active savings for the economy as a whole is not, however, theonly social role played by banks. Also of fundamental importance is theexistence and proper functioning of a payment system in which banks arethe main protagonists. The means of payment are the guarantee of the con-tinued implementation of most business transactions. Without these normaloperations, the economy as a whole would be paralyzed by the impossibilityof carrying out most transactions.

Banks have always been defined primarily by their function of modifyingand transforming liquidity. They are agents that can facilitate both thedesire of investors to hold liquid assets, such as short-term demand deposits,and at the same time meet the needs of borrowers for long term funds. Banks,in this sense, seek short-term funds and transform them into longer termloans. In addition and concurrently with this function, banks also operate

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Francisco PINTO, Rogério SOBREIRA

10 Journal of Innovation Economics 2010/2 – n° 6

the mutation of liquidity by turning longer maturity bonds with low liquidityinto highly liquid assets such as deposits. This is the environment in whichthe ‘meeting’ between borrowers and investors occurs, thereby reducing anyindividual differences between them. Without the existence of these chan-nels there would be huge transactional costs to converge the interests ofinvestors and borrowers.

Discussions about financial markets almost always focus on their role inmobilizing savings for industrialization. In reality, financial markets are muchmore than the supposed movements mentioned above, while the question ofhow they perform these other functions can affect not only the extent towhich they can mobilize savings, but, more broadly, the efficiency andgrowth of the global economy.

In the last two decades technological improvements, financial innova-tion and deregulation have exerted (and still continue to do so) intensetransformation pressure on the financial system in the modern world. Banksnowadays do not resemble in any way banks of the past. In reality, they seemto have very little in common with banks of a decade ago. Changes haveoccurred not just in content but, above all, in the agents involved and thespeed at which changes have happened. Various different approaches todealing with this have been proposed, focusing on a range of causes, such asthe characterization of the banking market structure, the degree of concen-tration, its effects in relation to banking results performance (focus on risk/return, economies of scale, growth, etc.), and relationships with differentcustomers and suppliers.

Specifically in the case of banking information technology, the align-ment of the contribution of the technological area features the keyword ofeffectiveness. The advantages brought by technological innovation, such asthe involvement and promotion of the diversity of modernization in finan-cial products, enable large banks to be more agile and flexible in the gener-ation and management of various financial products than small banks,which lack the scale required by the challenges of financial innovation. Thecentral idea is the concept that the main forces in the financial systemaffected by information technology are those involved with the asymmetricinformation and transaction costs. As a result, both the role of financialintermediaries and the structure of the financial system eventually sufferintense transformations.

This paper discusses the main points regarding the impact of this scenarioon the banking industry. The paper is organized as follows. Section 1 pre-sents a discussion of the transformation observed in the banking system as aconsequence of some technological innovations, discussing their impacts on

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Financial innovations, crises and regulation: some assessments


the payment systems which caused dramatic changes in loan agents and theimpact on the main credit and derivatives markets which opened possibili-ties for agents to achieve new levels of risks. Section 2 examines the essenceof banking fragility and systemic risk, discussing the appropriate treatmentto be given to the risks involved in the operation of modern banking, andalso discusses the impacts of the behaviour of these new banks on bankingregulation. Section 3 4 concludes the paper, arguing that in spite of the lim-ited capacity of financial regulation and supervision to control the range ofrisks of the banking system, it can nonetheless minimize the obvious weak-nesses of markets, reducing the possibilities of occurrences of systemic crises.

THE NEW BANKING SYSTEM

The widely used advantages of electronic payments reduce the attractive-ness of holding bank deposits for longer times as was required when usingchecks. In other words electronic payments increased speed and system effi-ciency, whilst reducing the need to hold deposits for longer terms. Thisexample alone, as recalled by Chami et al. (2003), raises pressures for dra-matic changes in loan agents. The policy shift of fund managers to operateadministration at shorter intervals requires more transparency in gains andlosses, exploiting the more agile players, either through better managementof funds in a scenario of fast movement of resources, new tariffs, fees and pay-ment services, or in the opposite direction by punishing those who havemore difficulty in adapting to this environment.

From a strictly financial point of view it can be said that the speed inoperations in turn leads to a reduction in service costs and a decrease inexpenses that has an important effect on the financial liabilities of institu-tions, especially banks. In the past most payments were made using checks,which offered more possibilities for a natural source of financing for com-mercial banks since they retained these funds for longer periods in currentaccounts. This suggests that the reliability generated by these funds mayhave been critical to the special role of banks in financing companies,thereby confirming benefits to borrowers who established long term bankingrelationships since longer maturities were to meet higher insurance guaran-tees provided by banks. In other words, if the period funds remain in currentaccounts changes intensely, it is undeniable that product profiles and bankguarantees will also alter.

In recent years the settlement of expenditures through electronic pay-ments has increased dramatically. Initiated primarily with ATM terminals,electronic transaction technology is still developing and expanding rapidly.

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The number of ATMs has consistently risen and as a result of this growthbanking transactions have expanded. Furthermore, the use of credit cardsand debit cards to perform retail payments has also increased rapidly. Morerecently, the advent of internet and telephone banking, or even a combina-tion of these two, has ensured a final consolidation, expanding and extend-ing other means. Thus, the increment of the existence and efficiency ofelectronic payments reduces the need to retain bank deposits. A wide rangeof payments through credit cards, even small ones, can be made and a singlepayment processed once a month, possibly through another electronic pay-ment. The set of average balances in current accounts can be much smallerthan in the past when consolidating payments in this way. In reality, thesevalues are migrating to diverse funds offering better rates.

On the one hand, improvements in information technology and theimpacts of this on information asymmetry and transaction costs enableinvestors and banks to obtain better information, to be better prepared toperceive differences between good credits and bad debts, to otherwise betterassess the risk of a potential customer, and to monitor more effectively themarket, thereby reducing the problems of adverse selection and moral hazardresulting in the lowering of barriers to the issuing of credit and other bankproducts, thus encouraging the use of these products. On the other hand,immense possibilities are also opened for new types of risks that were notpreviously present in the banking market.

The key issue related to the impact of information technology on creditand derivative markets dramatically varies depending on the extent condi-tions for risk taking were altered. Increased incorporation of informationtechnology resources and the monitoring of risk levels have lowered the bar-riers for the expansion of these markets. In other words, the advent of com-putational models with greater range and higher performances has greatlyassisted assessment in risk decision making, an area previously treated withmore caution.

It is in this context that the development of financial products associatedwith higher risk technology found a special base to expand markets amonglower socio-economic groups and micro-businesses, who generally did nothave sufficient assets and guarantees to be offered credit in securities lendingoperations. With the expansion of the volume of information offered by newtechnologies, however, these social sectors came to rely on their own pay-ment history, which is their ‘guarantee’ in the form of reputation for variouscredit markets. With these instruments the risks of default seemed to end. Inessence, they were virtually ignored, offering the perfect basis for properbusiness expansion and a lowering of the cost of credit. In other words, the

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extension of credit markets favoured by better technological tools estab-lished ‘subprime’ layers of new consumers, but without better guaranteeinstruments for the risks involved, which clearly explains the consequencesof the mortgage credit crisis which arose in the roots of the subprime entrysegment. This system created strong competition among banks, encouragingbanks and finance companies to seek new markets 1 that promise additionalearnings. However, it was known that the risks associated with these mar-kets had not essentially changed. 2 Furthermore, in addition to subtle waysto dilute and distribute risks, technology also contributed much in thisregard.

The accelerated pace of technological progress has produced a financialsystem in which the tools for better decision making, and as a result the levelof information, have stimulated the opening up of credit markets, such assecurities, to a level of retail and income never before imagined. All thismovement has led to a decline in the traditional brokerage acquisition offunds. Financial intermediaries are now working in order to break downrisks, allowing assets to be financed by larger number of less informed inves-tors, thereby enhancing a wider range of liquidity.

Derivative markets, in turn, essentially arose out of the advent of newtechnology. Until the 1980s banks made loans and used these to managetheir portfolios. However, the new technological scenario required speed,diversification and expansion of markets, bringing the need for risk mitiga-tion. Securitization, in part provided and facilitated by information technol-ogy tools, is the process by which financial agents forward the transfer ofcredit risks by granting it and retaining it in more sophisticated debt distri-bution portfolio products. With the help of managing and monitoring tools,loans were shared and aggregated in order to be transformed into specificfinancial products and in turn were traded in secondary markets.

The origin of derivatives markets is linked to reasons of both supply anddemand. The macroeconomic turbulence of the 1970s, associated withinstability in interest and exchange, probably raised the demand of compa-nies for a better management of systemic risks. On the supply side, a betterframework of financial theory allowed institutions to perform at lower costsin these markets. Options markets, in turn, took off after Black, Scholes and

1. The most promising market was the mortgage market in the United States whose stock ofmortgages was valued at 10 trillion dollars (Carvalho, 2008).2. Some works, such as those of Edwards and Mishkin (1995), raised the possibility that banksthemselves often fail to effectively control the risks incurred by their employees as a result ofthese new financial technologies, featuring a typical problem of the relationship between agentand principal.

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Merton 3 showed how to create synthetic options, taking long and shortpositions in underlying securities. This fundamental perspective led to a newfield of finance - financial engineering - where the mathematics associatedwith computing-intensive algorithms provides pricing and managing risksassociated with any derived evidence that depends only on the movement ofexchange rates, underlying interest rate etc. The derivatives market hasexpanded with technological support, increasingly sharply in recent years.

BANKING FRAGILITY, SYSTEMIC RISK AND BANKING REGULATION

Some structural weaknesses result from the nature of banking activities,since banks operate under a constant inherent financial fragility with thecontinuing existence of contrasts on both sides of their balance sheets. Onone hand, there is the rigidity of the liquidity value of the liabilities, and onthe other the slow liquidity and flexibility of assets (Lima, 2005). Banksoffers the public obligations which effectively have no such need to behonoured. Bank debt constitutes in fact in a large part of demand deposits,which in reality are promises of delivery to depositors, specific values at thelegal currencies. When capturing assets, banks create deposits in the shortterm. However, they keep in reserve only a fraction of bonds issued in theform of deposits (fractional reserve) and, following this logic, can only fulfila portion of deposits at any given moment. Therefore, the bank can only actif the trust of investors is strong enough so that withdrawals are kept at levelsthat can be effectively covered by reserves held by the institution 4. In the-ory, if not all depositors recognize that the bank cannot honour their appli-cations at the desired time, a problem of reputation can be created withunpredictable consequences. Under normal conditions, however, it is muchmore convenient to operate a business transaction with the bank instead ofthe required legal currency itself. In reality, there is no incentive to serve the

3. Merton was the first to publish a paper expanding the mathematical understanding of thestandard pricing of options and coined the term ‘Black-Scholes options pricing model’, praisingthe work written by Fischer Black and Myron Scholes, first published in 1973. The vision ofBlack-Scholes was that the price of the option is implied if the shares have been sold. Mertonand Scholes received the 1997 Nobel Prize in Economics for this work and other research.4. If all depositors decide to withdraw their values at the same time, the insolvency of the bankwill result in asset devaluation as banks, in order to honor their commitments, consume theirliquidity reserves, and once these reserves are consumed banks need to commercialize their assetsin secondary markets, although this is difficult to do as well. It is important to note that banksuse the interbank market and ultimately the lender of last resort, in general central banks; inorder to manage their needs for liquid reserves.

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lawful currency while there is confidence that the bank is able to do so ifrequired.

If, however, reputation problems continue and depositors are concernedthat a bank is unable to honour its commitments (either with their ownresources, either using the interbank market) 5, they shall immediately drawon their reserves. Nevertheless, when this failure causes the public to doubtthe capacity not only of one bank, but of others, i.e., when banks’ reputa-tions are no longer enough to protect them from a widespread movement,the phenomenon of widespread attempted withdrawals is reported. Since itis known that the initial withdrawal demands of depositors are met in full,while later ones are likely to get nothing, a race to withdraw, or a so calledbank run, is started. In this case, the single most rational attitude is not onlyto get money out of the bank, but do so as quickly as possible, before anyother more agile depositors can do it 6.

Apart from the above mentioned weaknesses, there is also a complex net-work of high-value positions among banks through the interbank market andpayments, and consequently through security settlement systems. Indeed,banks tend to play a crucial role in settlement systems and retail payment.Exposure to adverse risks in banking generates real probabilities of bankingdefault for payment commitments that generate risks of immediate impactson the ability to fulfil obligations to other banks. Even more intense is a cri-sis that can generate a number of technical difficulties in performing the var-ious steps of the payment and settlement process, resulting in domino effectsfor other banks.

Looking at the above statement it can be noted that with the increase ininformation evaluation and estimation (valuation), loans and bank assetsthat were previously retained in the balance sheets of financial intermediar-ies have become marketable and liquid (Chami et al., 2003) and, therefore,negotiable. As previously mentioned, the use of automated decision-makingand credit classification for residential mortgage loans, credit cards, andloans for small businesses not only reduced the fixed costs of such loans inthis environment, but also offered financial institutions an understanding ofthe sorting, packing and packaging risks, allowing them to create informa-tion from securities with very little transparency, where most of the credit

5. The interbank market works as an insurance mechanism between banks, to the extent thateach funds the liquidity needs of others, in order to dilute the liquidity risk of each institution.Thus, if a bank has temporary liquidity problems, it can look for help in the interbank market tofund its needs (Cortez, 2002).6. A classical reference to this systemic risk can be found at De Bondt and Hartman (2005).

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risk associated with the title remains with the bank, while the majority offunds comes from other markets.

An environment of perceptive low risks, coupled with the complexunderstanding of the functioning of derivative transactions and securitiza-tion, might have been enough to generate the broth for the formation of acredit crisis by itself alone (Sobreira, 2008). The crisis, though commonlyassociated with the bad performance of subprime mortgages, was undoubt-edly boosted by the behaviour of the derivatives and securitization markets.It is the logic of operations of these markets that explains the intensity of thedecline observed lately. This logic, unless redesigned by new forms of regu-lation, will remain in force in the market, maintaining the high level of riskof the operations involved, making it more difficult to define the extent oflosses. This leads to the necessity to change the philosophy of the currentbanking regulation.

The banking and financial sector system has always been strictly con-trolled by governments and public authorities, especially after the 1930 crisiswhich caused serious damages to global economy at that time. After the1980s, however, the banking framework started to change, as a strong move-ment of deregulation took shape, increasing spaces of banking autonomyand drastically transforming its nature. The development of technologies forprocessing and transmitting information and data, as well as the financialtechniques cited in the preceding paragraphs, provided new means for thepreparation and distribution of financial products and services (EuropeanParliament, 2000). The growth of international flows of trade and capitalrequired new products and services and, as a result, companies that couldprovide them. The new business environment needs greater performanceand capacity on the part of the new banking company, a scenario that endedup pressing local and regional governments to allow more deregulation intheir banking markets. The main feature of this process was the gradualelimination of market segmentation and the expansion of the degree offinancial openness among regions and countries. Market deregulation inturn, in addition to changing banking profiles, has brought increased com-petition not only among banks, but also among other financial institutionsas claimed by Sobreira and Pinto (2008).

The set of events mentioned in the previous session, together with finan-cial deregulation, led to the creation of more complex financial institutions,operating in multiple segments of the financial market, with freedom ofchoice in contexts of greater uncertainty when compared with precedingperiods. Market opportunities, and consequently the associated risk,increased in this new scenario. What is not surprising, however, is the fact

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that occurrences of instability took place in far greater number than at anyother recorded time in the financial history of the last century. In fact, as theelements that allow more advanced operations are created, in parallel theyarise greater difficulties in tracking and monitoring these complex opera-tions. The specific and special capacity of banking operators cannot beaccompanied in real time by the specialization and training of regulators andsupervisors. Even the management of the bank itself cannot have full con-trol of all its operations. In other words, the tools and expertise required tomonitor and control risk does not necessarily arise alongside the develop-ment of tools for decision-making and mapping. This whole scenario turnsout to encourage a change in the philosophy of the prudential regulation.

A better understanding of how to answer this question first involves adissection of the current circumstances where precepts based heavily on therecommendations of the Basel agreements, consisting of capital ratios inrelation to assets, have apparently proved imperfect or ineffective in curbingthe risks assumed by financial agents, i.e., current regulation, subordinatedto the dictates of Basel, operated and supervised by independent centralbanks, seems not to have had enough strength in the case of U.S. subprimemortgages to prevent the insolvency of large institutions. This assertionintuitively points to the necessity to expand or alter requirements, while adeepening of this understanding leads to reforms that may suggest that themodification of current regulation requires new procedures to limit thefinancial transactions at the root of the spread of this sort of crisis. Addition-ally, it can be assumed that the monitoring of institutions by themselvesusing self-management models, alongside presumed market discipline andsupervision at a distance by central banks, has not had the desired effect.Since Basel II accepted and encouraged the filling of risks taken by privateinstitutions by external agencies or the banks themselves, it indirectlyoffered the possibility of the mindset inclusion of market actors in the regu-latory framework, understanding that financial institutions would be moreapt to manage the volume of capital to be maintained on their risks in thisself-supervision model rather than in any other instance. The logic, there-fore, that pervaded and still pervades these arrangements, in particular BaselII, is that the management of risk held by each institution would tend to leadto systemic stability – a fact that apparently was not true, given the evidenceshowing that such a framework of self-management was not able to avoidproblems of this nature and magnitude due to the extensive presence of theeffects of distrust of self-supervision of risks shown in the subprime mortgagecrisis.

It is also important to mention that financial innovations such as securiti-zation, which eventually withdrew the risks from the institutions’ accounting

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balance sheets, to be assumed, as shown by Farhi et al. (2008), by agents ofthe “shadow banking system” 7, making the impacts of the financial instru-ments more complex and difficult to visualize (Mendonça, 2008) were notsubject to the norms of the Basel Accords. As a consequence, the central pil-lars created by the dictates of the Basel agreements do not necessarily respondto crises such as the one mentioned above. It is, therefore, evident that acomplete change of the whole framework regulation set of the internationalfinancial order is required, which may impose limits on existing statutes,such as the self-regulation of agents and financial markets, derivatives, secu-ritizations, high levels of leverage and the permissiveness of organizationslike financial supermarkets to financial innovations.

However; the emphasis on the introduction of extensive prudential reg-ulation and supervision in real time may still not necessarily offer all neces-sary guarantees, whilst possibly inhibiting financial ventures or stimulatinginnovation that may be relevant. Regardless of its innate difficulties facing amarket that is more agile, regulation that can possibly produce benefits canarise out of a focus on the following points:

• Revision of the legal framework for funds recorded outside the balancesheets of banks, which are virtually unregulated and whose artifice is invari-ably confirmed to reduce the minimum regulatory capital required. In thissense, capital requirements should include liquidity obligations assumedwith ‘off-balance-sheet’ vehicles, which will involve the valuation of illiquidand complex financial instruments where regulators can restrict or confinethe complexity of instruments that can be issued by regulated entities.

• Similarly, one must not underestimate counterparty risk. 8 Economieswith higher organizational levels can mitigate the occurrence of this by the useof clearing houses, which interpose guarantees between the parties for theproper performance of operations (Farhi and Cintra, 2009). Assuming forexample that all derivative credit contracts based on operations are made,recorded and secured in a clearing house, would help shift the delivery risk tothe clearing house, which would not hesitate to take the necessary precaution-

7. The term ‘shadow banking system’ includes the range of institutions involved in leveragedloans that had no access to deposit insurance and/or to the rediscounting operations of centralbanks. It covers big independent investment banks, hedge funds, pension funds and insurers. Inthe U.S., regional banks specializing in mortgages and government-sponsored agencies are stillcovered (Farhi et al., 2008). This term was first coined by Paul McCulley, chief executive of oneof the largest asset management company in the world, Pimco.8. Investment banks and the financial community in general are at huge risk of being a counter-party to each other. The insolvency of the U.S. banks Bear Stearns and Lehman Brothers in therecent mortgage crisis was derived above all from their debts to their counterparts on account ofderivative mortgage papers.

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ary measures such as margin calls and collaterals, preventing obligations frombeing honoured where a default by one party may lead to a systemic crisis.

• Implementing the requirement of countercyclical reserves, (Danielsonet al., 2001). In this sense, as well argued by Carvalho (2005), the risk assess-ment is strongly (and inevitably) influenced by subjective evaluations,which at any given time may be shared by other market participants. There-fore, a similar feeling in the global market which could lead banks to under-estimating risks in a cyclic period of prosperity would be likely to be sharedby other market players, even though all involved are fully aware that pros-perity may be temporary. Thus, the opportunity of generating profits duringthis cycle is stronger than the inclination to careful conduct. In other words,market discipline can be a force to enhance the action of regulators, but canhardly replace their behaviour.

• Overseeing the philosophy and the categories imposed by rating agen-cies. The prevailing belief is that rating agencies are effective in monitoringthe financial health and the risks involved in each market agent. However,the risk analysis of complex instruments such as derivatives requires exper-tise, agility and technological upgrading, which invariably is not readilyavailable to rating agencies in general.

• Review the existing requirements of hedge funds and private equitywith regard to financial stability, excessive debt and financial leverage.

• Although it is more controversial, the pursuit of more conservativemonetary policies by central banks should not be dismissed as precautionarymeasures. Generally, the heightened valuation of certain assets is correlatedwith expansionary monetary policies practiced by central banks (Calomiris,2008). An accommodating monetary policy, as also highlighted by Bordoand Wheelock (2007), has always been the key factor in all price cycles andcredit assets of any kind. The excess of a phenomenon of credit expansionis always at the centre of an asset bubble and is certainly the starting pointfor understanding a crisis. 9 Asset prices should be part of the toolset for

9. The U.S. mortgage crisis resulting from the excessive valuation of real estate assets showed astrong correlation between the accelerated growth of the U.S. monetary base from the second halfof 1990, under Alan Greenspan, in contrast to the contractive era under Paul Volcker 1979 to1987, with price and assets stabilization and the consequent normalization of the banking market,but with the unpopular policy of raising the basic interest rate. The subject, however, is controver-sial because the same contractionary monetary policy, according to Gontijo (2008) led many banks(Savings & Loans), to experience significant losses of revenue, as depositors transferred theirmoney to market funds to increase profitability, a loss that occurred at a time of strong growth inthe mortgage market, where such institutions used long-term mortgages with fixed rates of interest,so that with rising market interest rates the present value of housing loans fell below the face valueof bonds, eroding the stock of S&L’s putting down roots for future crisis (Morris, 2009).

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developing monetary policy as central banks cannot control how the moneyin circulation is allocated, but can try to control its supply.

Although duly agreed and implemented, the extensive and additionalregulatory provisions, however, have not completely immunized the finan-cial market from the occurrence of new crises, which are inherently presentin the capitalist financial system. It is necessary to recognize the limitedcapacity of financial regulation and supervision to monitor the quality ofclaims held by the banking system in the face of the various types of risks,Farhi et al. (2008), and the inherently instability of this activity. The verydynamics of the banking market system promotes the underestimation ofrisks and the pursuit of new products and tools to circumvent the limitsimposed by state regulation. Recognizing these limits does not imply thatthe state should relinquish its essential function of regulating banking andfinance, even though it is essentially difficult to stay ahead of problems. Thefigure below illustrates our main arguments.

Figure 1 – Additional outbreaks of regulatory action for market equilibrium

In relation to the revision, expansion, or adaptation of banking regula-tion to new times, it is worth remembering that the principles of regulationshould always be justified by their benefits. Since regulations of any kindalways impose costs on the business regulated, circumstantial evidence of itsbenefits can no longer be enough. Its object should, therefore, be strictlynecessary to protect the public service and consumer services involved, inaddition to systemic risks. In the case of banking, due to the aspects already

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mentioned, financial regulation should attempt to not impose too manyrestrictions which might hinder open market operations, preventing orrestricting the challenge of new entrants, innovations etc. or, in otherwords, not constraining the actions of competition.

In economies with a large number of small banks like the U.S., the eco-nomic consequence of the decline of small institutions is limited to theregions or sectors in which they operate. However, in a market situationwhich impacts on large banks, even a banking system with several agents;the effects are far more serious. These banks have economic strengths andfinancial relations with other banks with reciprocal credit in the interbankmarket and a high volume of compensation payments.

CONCLUDING REMARKS

Disassociated from classical economic rationality, the banking industry isprone to runs in the event of adverse economic instability. However, in ascenario where large international banks operate sophisticated channels ofcredit transactions and risk assessment, it is necessary to improve the finan-cial regulation. There is certainly a case for disclosure, greater transparencyand rapid dissemination of critical information by banks in order to increasethe effectiveness of banking supervision.

In this sense, since it is always difficult to anticipate the direction thatmarkets will take, financial regulation should be as dynamic as possible. Itsfull operation will help to minimize the obvious weaknesses of the markets.The essence of its role is not exactly to prevent operations from being per-formed, but to guarantee to the market and to the economy itself that thosewho perform them are well equipped with assets to cover their bets andlosses. The main idea is to reduce systemic crises and to always give morebusinesses visibility and transparency, allowing the market more flexibilityand resilience to absorb shocks and alleviate crisis.

What must finally be recognized is the limited capacity of financial regu-lation and supervision to control the range of risks held by the banking sys-tem in the face of the inherently unstable financial activity. The verydynamics of competitive banking tends to promote an underestimation ofcontrol and strongly encourage the search for new tools and products thatbypass the regulatory limits. Recognizing these limits does not imply that thestate ignores its regulatory function in banking and finance, but that func-tion should be continually evolving in order to create an adequate bufferagainst misbehaviour of the market in its continuous search for high profits.

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Financial innovations, crises and regulation: some assessments

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