Is ‘market failure’ a good justification for financial regulation?

In economic analysis the case for regulation is normally situated within a “market failure” framework. According to this approach, if certain conditions necessary in theory for markets to maximise welfare do not hold, regulatory interventions can increase welfare in practice. Specific justifications for regulating financial markets within this framework were discussed by Llewellyn in the first Occasional Paper published by the Financial Services Authority (FSA) in 1999. They included information asymmetries between buyers and sellers; the importance of market confidence which has externality effects; consumer demand for regulation to lower transactions costs; and the need to address externalities caused by the systemic effects of the failure of a particular financial firm. In many respects, however, those who make the case for regulation pose a false dichotomy. The alternative to markets that are not regulated by the state may not be the absence of regulation, but regulation by non-state bodies. The relevant comparison is then between the efficacy of state regulation and that of regulation by other bodies. This paper examines the growth of state regulation, and historical and modern examples of private alternatives. It then provides a conceptual framework within which we can better understand the rationale for regulatory arrangements by the private sector. An argument is made that this framework is superior to the “market failure” framework. Finally, the lessons for regulatory policy are developed.