This paper first develops a theoretical model showing a concave impact of regulation on the probability of a crisis, and then tests this relationship by applying a non-linear Probit model to annual data from 138 countries over the period 1996-2017. Our key inference is that the probability of a financial crisis fits an inverted U-shaped curve: it rises as regulation stringency moves from low to medium levels and falls from medium to high levels.
Countries located in the intermediate level of regulatory stringency face more financial instability than either loosely or severely regulated countries. The latter two groups of countries are respectively caught in a “liberalization trap” and a “regulation trap.” Institutional quality interacts significantly with the regulatory environment, implying trade-offs between regulatory stringency and institutional quality.
The paper has been presented at the session “Which direction for capital markets in the EU and around the world?” organised by CEPS/ECMI in the context of the 2021 CMVM Annual Conference, held in Lisbon on 5 November.