Principles of financial regulation: A dynamic portfolio approach

Economists seeking explanations for the global financial crisis of 1997-99 are reaching consensus that a major factor was weak financial institutions, which resulted in part from inadequate government regulations. At the same time many developing countries are struggling with an overregulated financ ial system-one that stifles innovation and the flow of credit to new entrep reneurs and that can stunt the growth of well-established firms. In particu lar, too many countries are relying excessively on capital adequacy standar ds, which are inefficient and sometimes counterproductive. The author argue s that financial systems can be reformed successfully using a "dynamic port folio approach" aimed at managing the incentives anti constraints that affe ct not only financial institutions' exposure to risk but also their ability to cope with it. The article sets out general principles of financial regu lation and shows how the dynamic portfolio approach can help countries deal with the special problems that arise during the transition to a more liber alized economy as well as those that arise in dealing with a financial cris is similar to the 1997 crisis in East Asia.