This paper examines the role of the state in financial markets, identifying ten market failures that arise in financial markets, most of which are related to problems of imperfect and costly information. It proposes two alternative taxonomies of government intervention, focusing respectively on the instruments employed and the public policy objectives pursued. The paper develops a set of principles for government regulation which take cognizance of limitations on government, including limitations on the information it has at its disposal. These principles are then applied to the analysis of prudential standards for banks. The paper re-examines the role of the state in financial markets, identifying a set of market failures, examining the instruments and roles that government has played in financial markets, developing a set of principles for government regulation, and illustrating the application of these principles through analysis of prudential standards for banks. The paper discusses the role of government in financial markets, highlighting the importance of financial markets in the economy, not just in mobilizing savings but also in screening and monitoring investment. It identifies ten market failures associated with financial markets, most of which are information related. Information has many properties of public goods; differential information often gives rise to imperfections of competition; and because of difficulties in appropriating the returns to information, there are often externalities associated with the acquisition of information. Accordingly, it is not surprising that market failures arise in financial markets. The paper argues that financial markets are markedly different from other markets; that market failures are likely to be more pervasive in these markets; and that there exist forms of government intervention which will not only make these markets function better, but which will improve the overall performance of the economy. The paper provides the theoretical underpinnings from which a rational analysis of the appropriate design of government interventions in financial markets can be based. The paper begins by observing some salient aspects of capital markets: (i) Government interventions appear to be ubiquitous, even in highly developed financial markets, such as that of the U.S. (ii) There has been a long history of financial debacles, and there are large costs associated with these debacles. (iii) In spite of the attention paid to the stock market, even in more advanced countries such as the United States, relatively little new investment is financed by the issue of equities. (iv) Many of the innovations in financial markets are not welfare enhancing; they can be viewed as rent seeking expenditures. The paper identifies ten market failures associated with financial markets, most of which are information related. Information has many properties of public goods; differential information often gives rise to imperfections of competition; and because of difficulties in appropriating the returns to information, there are often externalities associated with the acquisition of information. Accordingly, it is not surprising that market failures arise in financial markets. Among the market failures are the following: (i) Monitoring solvency is a public good. (ii) Monitoring management is a public good. (iii) There are externalities of monitoringThis paper examines the role of the state in financial markets, identifying ten market failures that arise in financial markets, most of which are related to problems of imperfect and costly information. It proposes two alternative taxonomies of government intervention, focusing respectively on the instruments employed and the public policy objectives pursued. The paper develops a set of principles for government regulation which take cognizance of limitations on government, including limitations on the information it has at its disposal. These principles are then applied to the analysis of prudential standards for banks. The paper re-examines the role of the state in financial markets, identifying a set of market failures, examining the instruments and roles that government has played in financial markets, developing a set of principles for government regulation, and illustrating the application of these principles through analysis of prudential standards for banks. The paper discusses the role of government in financial markets, highlighting the importance of financial markets in the economy, not just in mobilizing savings but also in screening and monitoring investment. It identifies ten market failures associated with financial markets, most of which are information related. Information has many properties of public goods; differential information often gives rise to imperfections of competition; and because of difficulties in appropriating the returns to information, there are often externalities associated with the acquisition of information. Accordingly, it is not surprising that market failures arise in financial markets. The paper argues that financial markets are markedly different from other markets; that market failures are likely to be more pervasive in these markets; and that there exist forms of government intervention which will not only make these markets function better, but which will improve the overall performance of the economy. The paper provides the theoretical underpinnings from which a rational analysis of the appropriate design of government interventions in financial markets can be based. The paper begins by observing some salient aspects of capital markets: (i) Government interventions appear to be ubiquitous, even in highly developed financial markets, such as that of the U.S. (ii) There has been a long history of financial debacles, and there are large costs associated with these debacles. (iii) In spite of the attention paid to the stock market, even in more advanced countries such as the United States, relatively little new investment is financed by the issue of equities. (iv) Many of the innovations in financial markets are not welfare enhancing; they can be viewed as rent seeking expenditures. The paper identifies ten market failures associated with financial markets, most of which are information related. Information has many properties of public goods; differential information often gives rise to imperfections of competition; and because of difficulties in appropriating the returns to information, there are often externalities associated with the acquisition of information. Accordingly, it is not surprising that market failures arise in financial markets. Among the market failures are the following: (i) Monitoring solvency is a public good. (ii) Monitoring management is a public good. (iii) There are externalities of monitoring