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Financial Institutions Center

Banking Regulation versus Securities Market Regulation
by Franklin Allen Richard Herring 01-29

The Wharton Financial Institutions Center

The Wharton Financial Institutions Center provides a multi-disciplinary research approach to the problems and opportunities facing the financial services industry in its search for competitive excellence. The Center'sresearch focuses on the issues related to managing risk at the firm level as well as ways to improve productivity and performance. The Center fosters the development of a community of faculty, visiting scholars and Ph.D. candidates whose research interests complement and support the mission of the Center. The Center works closely with industry executives and practitioners to ensure that its researchis informed by the operating realities and competitive demands facing industry participants as they pursue competitive excellence. Copies of the working papers summarized here are available from the Center. If you would like to learn more about the Center or become a member of our research community, please let us know of your interest.

Franklin Allen Co-Director

Richard J. HerringCo-Director

The Working Paper Series is made possible by a generous grant from the Alfred P. Sloan Foundation

Banking Regulation versus Securities Market Regulation

Franklin Allen and Richard Herring*

Wharton School University of Pennsylvania July 11, 2001


Prepared for the Asian Development Bank Institute/Wharton Financial Institutions Center Conference on Financial Regulation,Securities Markets versus Banks, and Crisis Prevention to be held July 26-27, 2001 in Tokyo.

1. Introduction There is a long tradition of regulating banks and securities markets in many countries. The primary justification for bank regulation that is usually given is the avoidance of systemic risk, or in other words, the avoidance of financial crises. With securities markets it is usually argued themain purposes of regulation are investor protection and enhancing the efficiency of markets. Avoidance of systemic risk, investor protection and efficiency enhancement are not the only rationales. The achievement of broader social objectives, such as combating organized crime or facilitating home ownership, provides the justification for many other regulations. Table 1 summarizes the role ofdifferent types of banking and securities market regulations in achieving the four objectives of avoiding systemic risk, protecting retail investors and depositors, enhancing efficiency and achieving broader social objectives. It can be seen from Panel A that although banking regulation primarily prevents systemic risk most policies also impact a number of the other objectives. From Panel B securitiesmarket regulation is directed towards investor protection and efficiency enhancement. In recent years the relationship between banking regulation and securities market regulation has become an important topic. Emerging markets have been plagued by crises. The recent Asian crises are a good example. Most of these crises occurred in bank based financial systems and the non-contingent nature ofbanks’ liabilities appears to have played an important role in causing the crises. Banking regulation failed to prevent the occurrence of the crises. This has led a number of observers to argue that Asian countries should rely more heavily on financial markets for raising funds and


reduce the role of banks. This raises the important question of whether securities market regulation would need tobe changed to focus more on systemic risk. The purpose of this paper is to consider the inter-relationship of bank regulation and securities regulation in order to consider whether a move away from a bank-based financial system towards a market-based system is desirable in terms of crisis prevention. Section 2 considers banking regulation while Section 3 focuses on the regulation of securities...