A regime switching model of risk for the banking system

Abstract

The study of financial regulatory reform illuminates concepts such as "deregulation", "re- regulation" or "supranational regulation with domestic liberalisation". This paper specifies the nature of financial regulatory reforms. Based on the contents of changes on financial rules, it is argued that the incompatibility between economic integration and informational innovation on the one hand, and constraints on prices and quantities in the financial industry on the other, leads to the accuracy of the term "financial regulatory reform", despite the widespread (mis)use of expressions like " markets deregulation". Financial regulatory reforms carried out on western economies in recent years, aiming at preventing risks in the financial sector, underpin the design of a regime switching model of risk for the banking system that is developed in this study. This model derives its structure both from finance theory and econometric modelling. This regime switching model of risk for the banking system tests the hypothesis that risk in the banking system may have increased in the course of financial regulatory reform. It is concluded that the idea that financial liberalisation, as well as the new rules that followed, may have induced banks to act in their business dealings against the stability of the system does not hold good when the approach is stability from the profitability standpoint.