Indeed, risk-seeking is pervasive in the financial industry, as competition compels banks to seek higher returns. Regulation such as capital requirements can help to reduce risk-seeking behavior, although the negative affect such regulations have on value can ultimately encourage at least some degree of risk-seeking. Despite this unintended potential consequence, regulation serves to neuter overly aggressive bankers and reduces risk in the banking system. Reducing the risk in the banking system is congruent with the government's objective of making effective use of taxpayer money. A fourth consideration is that consumers demand regulation. While this does not constitute an economic case for regulation, it must be understood that governments are not motivated by purely economic considerations. Consumers want to know that their deposits are safe and that they can access money when needed for homes, vehicles and small businesses. Consumer demand, while irrational, is a key driver in the level of regulation in the financial industry.

Lastly, confidence in the banking system must be maintained. If confidence is lost, consumers and businesses will pull savings from the system, while would begin a cycle of economic contraction. The government, as part of its mandate to manage the nation's economy, must be wary of the degree of confidence in the banking system. This has, in part, compelled the government to extend substantial...

A conservative government will prefer a low-risk system, even if it means a low level of financial innovation. Canada and Australia are examples of nations with high levels of banking regulation, and while neither has a dynamic banking industry both countries fared well during the global economic downturn. By contrast, some governments will prefer looser regulation because of the innovations that occur, and because it unlocks untapped profit potential within the system.
Regulation is a means to control the risk level inherent in the system. As the recent financial crisis has illustrated, there are both pros and cons to having a low regulation, high risk financial system. The degree of regulation ultimately boils down to the risk tolerance of government vs. its desire to have a highly profitable, dynamic banking industry to help fuel its economy.

Works Cited:

Llewellyn, D. (1999). The economic rationale for financial regulation. Financial Services Authority. Retrieved November 13, 2009.

Hellmann, T., Murdock, K. & Stiglitz, J. (2000). Liberalization, moral hazard in banking, and prudential regulations: Are capital requirements enough? The American Economic Review. Vol. 90, 1, 147-165.