Theorizing Financial Regulation: Institutions and Instability in a Minskyian Framework

This article posits a theory of financial regulation based on Minsky’s concept of survival constraint and the Financial Instability Hypothesis. Recurrent financial collapses led modern States to create institutions designed to stop enforcing the penalties related to the survival constraint—insolvency—on commercial banks. Governments provide backup liquidity via central banks (lender/market maker of last resort) and bailouts through deposit guarantee schemes, but, in compensation, impose regulations on financial institutions. These rules try to emulate the prudent behavior regulators expect those agents would have adopted if they were still subject to the cash restrictions of the survival constraint. However, over time, the comfort of immunity from insolvency stimulates moral hazard, flaws, and financial innovations that weaken the effectiveness of regulation. As the financial markets evolve, creditors and debtors, driven by profit, make increasingly riskier allocative decisions as they introduce new products and services that comply with regulatory rules but increase financial fragility. Therefore, authorities must review regulations permanently to mitigate this behavior and deliver financial stability as a public good.