The increased resilience of one set of players, however, does not necessarily mean that financial markets function better overall. Some regulatory measures have created unintended side effects, such as reducing trading liquidity in certain markets and increasing volatility. Regulators have also at times extended new regulation from banks to other financial market players, without always fully taking into account differences in business models. One example is the classification of insurance companies as “systemically important financial institutions” that must hold additional capital for stability reasons – although capital plays a fundamentally different role in insurance compared with banking.
The conundrum at the core of this evolving regulatory agenda is the ambiguous impact of global financial integration. On the one hand, capital flows have a stabilizing function: they serve to distribute and diversify risk. On the other, when large shocks hit the financial system, its very interconnectedness can amplify the impact, as risk spreads far and wide through contagion. The result is a financial system that is “robust yet fragile” Recent reform measures have often addressed this fragility by trying to undo some of the interconnectedness. Many national regulators have implemented rules to ring-fence national assets. And despite considerable efforts to harmonize rules internationally, for example through the Financial Stability Board, national regulators increasingly add their own rules, which further hampers cross-border capital flows.
Hence, increased stability after the crisis has come at the price of a financial system that is also more fragmented and complex, and in some ways less efficient. Not surprisingly, many market participants view regulation as a major threat for their business while a number of economists have predicted that greater stability and safety in the financial sector would have costs in terms of investment and output growth.
Against this background, the European Commission’s initiative for a European Capital Markets Union (CMU) came as somewhat of a surprise. It could represent Europe’s turning point in this regulatory cycle.