Oxford Review of Economic Policy, Volume 27, Number 3, 2011, pp. 397–410 Banking, finance, and the role of the state Xavier Freixas * and Colin Mayer ** Abstract This paper provides an overview of the issue. It considers the existing structure of financial regulation, the deficiencies that were encountered during the financial crisis, and the proposed reforms. It discusses whether these are likely to be adequate and argues that there are fundamental failures in product markets, capital markets, and government relations with financial institutions highlighted in the articles in this issue that question whether current reforms will prove sufficient. In particular, the article argues that a clearly defined partnership between the state and the banking system needs to be established by which the state protects certain core components of the banking system that perform key functions in an economic system and well specified rules are put in place to avoid renegotiation and lobbying. Key words: banking, regulation, systemic risks, the state JEL classification: G21, G28 I. Introduction The financial crisis has been the single greatest economic shock of the twenty-first century to date. What has traditionally been regarded as a dull, conservative sector of the economy has brought several economies to their knees and inflicted serious wounds on others. This has raised many questions about the role of bankers, credit-rating agencies, and regulators, to name a few, in the failure. But more generally it brings to the fore the relation of the state to the financial system in general and the banking system in particular. The importance of the state has been revealed in three dimensions. First, the fundamental significance of the financial system to the functioning of economies has been emphasized. There was a view in some quarters that the financial system is just the handmaiden of the real sector. 1 It lubricates the operation of the real productive side of the economy but it is not of primary importance in its own right. No more—it is now all too evident how a malfunctioning financial system can have devastating consequences for real economic activity. Second, the state’s responsibility to ensure the viability of the financial system is now clear cut. Banks and the payments system are part of the commanding heights of an economy and *Universitat Pompeu Fabra, Barcelona Graduate School of Economics, and CEPR, e-mail: xavier.freixas@upf.edu **Saı ¨d Business School, University of Oxford, e-mail: colin.mayer@sbs.ox.ac.uk 1 Robert Lucas (1988) dismisses finance as an ‘over-stressed’ determinant of economic growth (p. 6) and Joan Robinson (1952) argued that ‘where enterprise leads finance follows’ (p. 86). doi: 10.1093/oxrep/grr023 Ó The Authors 2012. Published by Oxford University Press. For permissions please e-mail: journals.permissions@oup.com Downloaded from https://academic.oup.com/oxrep/article/27/3/397/596737 by guest on 08 March 2021