Is Modern Finance Geared Up to Support Financial Regulation?

Abstract

The chief intellectual assumptions behind financial regulation are that capital market are efficient and market participants act rationally. These assumptions have always been subject to some challenge and their empirical verification occupy a large portion of modern finance literature. Nevertheless, they have been the leading financial markets theory during the decades preceding the 2007-8 crisis. The crisis has shown that modern theory does not allow for solid risk assessment and reliable macroeconomic forecasting. Such challenges suggest that modern finance may be facing a paradigm crisis. In this paper, we take the measures to such crisis. The reaction of the regulators to the financial crisis was immediate and massive, but the reforms they brought about were built on top of the same theoretical framework that supported the pre-crisis environment. On one side, we suggest that a debate must be opened to assess how to move forward from the current mainstream paradigm; on the other side, we concede that today there are no viable alternative that can replace the current paradigm. Finally, we invite to challenge the rationale behind new financial regulation based on models that have failed in the past. The goal of the regulators should not be to eliminate the financial crises, nor the financial risk, but rather to facilitate an environment in which risk assessment is made more reliable.

Author

• Massimiliano Neri
  Director of Moody’s Analytics and the Finance Research Center at Universidad Francisco Marroquín. In addition, he is a professor of Financial Risk Management at OMMA (Manuel Ayau Center for Advanced Online Studies in Madrid) and visiting professor at Universidad Francisco Marroquín.