Edited by Christopher J. Green, Eric J. Pentecost and Tom Weyman-Jones
Chapter 5: The Economic Rationale for Financial Regulation Reconsidered: An Essay in Honour of David Llewellyn
Richard J. Herring and Reinhard H. Schmidt1 INTRODUCTION AND OVERVIEW 2009 was the tenth anniversary of David Llewellyn’s classic work, ‘The Economic Rationale for Financial Regulation’ (Llewellyn, 1999). It was the first Occasional Paper issued by the FSA and provided a plausible rationale for what the new institution was designed to accomplish. Llewellyn gave a thorough and balanced assessment of the economic rationale for financial regulation, written with his characteristic clarity and elegance. This perspective of a well-respected, mainstream economist became widely cited and, indeed, often appeared on college syllabi. Since the 1990s, financial instruments, markets, institutions, regulations and macroeconomic conditions have changed markedly. Notably, innovations in derivatives have increased and tended to blur the traditional lines between financial institutions. Capital markets have become much more important in the operations of large financial institutions, and large, complex financial institutions have become more numerous, even larger and even more complex. For example, the top five banks controlled 9 per cent of world banking assets in 1998; now they control well over 18 per cent. Moreover, the Basel I guidelines for capital adequacy have been adopted by more than 125 countries, often with the unexpected result of encouraging the growth of off-balance sheet transactions that substitute for more heavily regulated on-balance sheet assets. Basel II has replaced Basel I in several countries and has been extended to what were the five largest investment banks, with the unintended consequence of greatly increasing leverage. Moreover, accounting standards (which, although unacknowledged, have always been critical...
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