The costs of state intervention in the financial sector

Abstract

We analyse costs and benefits of banking regulation and supervision to determine whether more supervision is always better for the functioning and stability of the banking sector. Whilst the motives for additional regulation are well understood, their social costs are not and hence net social benefits of additional regulation remain unclear. We emphasize that also in regulatory terms there is no free lunch; regulation-much like taxation-creates social costs and these may exceed the benefits so that society is actually worse off with than without (additional) regulation. And our argument is more intricate than that, suggesting that if the layers of regulation in place before the crisis have given poor incentives to those in the financial industry and their clients a revision or even reduction of regulation might generate a more stable financial system that is more friendly towards its customers. Financial regulation proposals should ultimately align the behaviour of financial institutions with social preferences. That strongly implies that the political discussion on regulatory proposals should reflect a full overview of relevant benefits and costs. The current situation is far from this theoretical optimum in our opinion. Politicians voice the public outrage over financial institutions that are supposedly at the root of the global financial crisis and often seem most intent to increase consumer protection and reduce taxpayer exposure.