This chapter looks at how the interaction between politics and financial markets, interfaced through regulation, creates a financial-regulatory cycle. The chapter builds on the previous literature through two threads: firstly by discussing the basic mechanisms of institutional development to understand where regulation comes from. And secondly, by looking at the development of ideas around the political economy of financial regulation to understand how the state operates in markets. These two strands lay the groundwork for the idea of the financial-regulatory cycle.

Cumulative causation and the forming of a cycle

The basic mechanism identified is that of a cumulative cycle of bank regulation with bank activity (Myrdal 1956). The ultimate basis of this understanding is Minsky's financial instability hypothesis: that finance is inherently unstable due to the increasing risk appetite of market participants as a market goes through a boom, which then at some point turns into a bust. Regulation is intended to provide stability, but the recurring nature of financial crises shows that it is unable to. This cumulative cycle means that bank regulation is progressively loosened as banking activity picks up during the boom, and tightened when bank activity reduces, usually after a market disruption: it is pro-cyclical.

Another way of saying this is that regulation and banking activity build off each other. Growth in financial markets encourages political actors to relax regulatory standards because the salience of financial stability is reduced on the political side and the financial benefits of reduced regulation is more obvious on the market side (as part of the increased risk-taking that Minsky shows). Then the social costs of a market bust suddenly increase the salience of financial stability – as well as lessons-learnt about “what went wrong” – which encourages the public sector to impose much stronger regulation on banks. But the form this “stronger regulation” takes is not necessarily, or solely, formed through an understanding of what banks “need” to be stable: indeed it cannot be since what the bank “is” is altered by the very regulation that aims to control its behaviour. The form of the “stronger regulation” that comes about happens because bank regulation itself is formed through a political rather than economic process, and represents compromises derived from divergent interests, ideas, and institutional forms.