The Role of the State in Financial Markets

This paper re-examines, from a theoretical perspective, the role of the State in financial markets. After observing the ubiquity of government intervention and the frequency of debacles in the financial market (such as the U.S. S&L debacle), it identifies ten market failures that arise in financial markets. Most of these are related to problems of imperfect and costly information. It then proposes two alternative taxonomies of government intervention, focusing respectively on the instruments employed and the public policy objectives pursued. Government intervention faces information problems as well. The paper develops a set of principles for government regulation which take cognizance of limitations on government (including limitations on the information it has at its disposal). These principles are then applied to the analysis of prudential standards for banks.