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PKSG Working Paper Series

Working Paper PKWP1403

How financial innovation might cancel out bank regulation along financial cycles. A Keynes's state of confidence interpretation

February 2014

Konstantinos Loizos

The question posed in this paper is how financial innovation may render conventional bank regulation ineffective. It is argued that the root cause as well as the essence of financial innovation is the predominance of trust in the financial markets, as it is confidence in the financial markets which makes the acceptance of financial innovation possible. In particular, mutual trust in the interbank market depends on the degree of confidence by which expectations are held, which, in turn, affects the relevant risk premia. Consequently, bank regulation may fail to accomplish its stabilization purpose if it cannot check overconfidence in the upswing or inspire and redress lack of confidence in the downturn.

Keywords: Financial innovation, bank regulation, state of confidence, financial cycles

JEL classification: G01: Financial Crises G28: Financial Institutions and Services: Government Policy and Regulation

Download: Working Paper PKWP1403