The Stability of the Banking Sector: Dealing with Marketability and Complexity

This paper focuses on the proliferation of financial innovations as a decisive force affecting the stability of the financial services industry. A fundamental feature of more recent financial innovations is their focus on augmenting marketability which makes banks and financial markets more intertwined. We argue that the more intertwined nature of banks and financial markets adds complexity and induces opportunistic decision making and herding. In doing so, it has exposed banks to the boom and bust nature of financial markets and has augmented instability.

Building on this, the paper discusses whether capital regulation and market discipline might be effective at countering the elevated instability. We will argue that market forces might be at odds with financial stability and point at institutional and regulatory changes that might be needed. In particular, structural remedies are advocated in order to reduce the complexity of financial institutions.