policymakers demonstrate

498 Thorsten Beck, Elena Carletti and Itay Goldstein
between bank owners and managers, or because of lower costs of fragility. Keys
et al. (2011), for example, show how reduced incentives to screen borrowers in
the US due to the possibility of being able to securitize loans contributed to
higher loan losses.
In summary, both theory and empirical work suggest that financial innovation
can bring benefits but also increased risks both by the design of products
and through changing incentives. While financial innovation is thus critical for
the development of the financial system, it also poses significant challenges
for regulators. Regulatory frameworks are designed in light of existing products
and providers. They are mostly rule-based (and intermediary-based), for
example, for liquidity requirements only specific clearly-defined assets are considered.
Rule-based regulatory regimes have the clear advantage of providing
clarity, and reduce the room for supervisory overreach. They also guarantee
certain independence for supervisors, given the limited degree of freedom for
interpretation. On the other hand, rule-based regulatory systems are less adequate
in reacting to new products and markets, as existing rules do not refer to
them. A principle-based regime is more flexible in this context, but might be
more open to arbitrage possibilities.
While regulation might give rise to certain financial innovations, regulators
in turn will try to catch up with innovation, a process that Kane (1977) refers
to as ‘regulatory dialectic’. Compared to the financial sector, regulators are at a
disadvantage, as regulation (especially rule-based regulation) refers to specific
institutions, products and markets. Risk-based supervision would imply regulating
and supervising all financial intermediaries that offer the same products
under the same regime. For example, all institutions offering deposit services
should be subject to the same prudential regulation.
11.4.3 Complexity
One striking phenomenon over the past decades has been a clear trend towards
more complex financial institutions, which results in serious challenges for regulators.
Specifically, Cetorelli and Goldberg (2014) report that while in 1990
only one US bank holding company had more than 1000 subsidiaries, in 2012 at
least half a dozen did. Using data both for US and non-US banks with branches
in the US, they show that many of the leading banks have hundreds if not thousands
of subsidiaries, making it very hard for supervisors to properly monitor
them. Complexity can take on different forms, reflected not just in the number
of subsidiaries, but also in the expansion across different financial activities,
including investment banking, insurance, mutual funds, and even nonfinancial
activities. In addition, banks have organized their increasing variety
of activities often in multi-tiered ownership relations, with up to ten levels
of ownership links. Cetorelli and Goldberg (2014) also show that while the