Regulation and crises: A concave story

The paper develops a theoretical model showing a concave impact of regulation on the probability of a crisis, which is then tested by applying a non-linear Probit model, OLS estimates, and IV regressions to annual data from 138 countries over the period 1996–2017. The key result is that the probability of a financial crisis fits an inverted U-shaped curve. The latter rises as regulation tightens from low to medium levels and descends as regulatory strictness goes from medium to high levels. Countries located in the middle level of regulatory stringency are exposed to more financial instability than either low-regulation or high-regulation countries. The latter two groups of countries are caught in a “liberalization trap” and a “regulation trap,” respectively. Institutional quality interacts significantly with the regulatory environment, implying trade-offs between regulatory stringency and institutional quality.