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Unformatted text preview: easy scapegoat (blame the regulator if there is a problem). Third, investors outside the realm of the small depositor are but focus primarily on moral hazard because it is the only one that raises “prudential” issues, i.e., issues of risk management. 22 Moral hazard is a reflection of limited liability (limited capital). There is an important literature that questions the need for (and optimality of) capital requirements imposed from the outside. See in particular Kim and Santomero (1988), Berger, Herring, and Szego (1995), Diamond and Rajan (2000), and Allen and Gale (2005). 23 The literature has mostly stressed the “bright side” of wholesale finance, where small depositors free ride on the monitoring and disciplining services of larger investors (see for example Calomiris and Khan, 1991). However, Huang and Ratnovski (2008) recently showed that there is also a “dark side” to wholesale finance. In the presence of a noisy public signal on the state of the bank, wholesale investors may relax their monitoring and rely instead on an early exit as soon as there is any adverse change in the public signal, whether warranted or not. The fact that the smaller investors will stay put (which in their model reflects the presence of deposit insurance) facilitates the exit of the large investors. In this context, it is indeed surprising that the inherent tension within the deposit insurance as currently conceived—meant to cover only small depositors in non systemic events but de facto exposed to systemic losses resulting from early runs by the large depositors—has not received more attention. 24 There is a vast and rapidly expanding literature on the underpinnings of the demand for liquidity and the drivers of liquidity crises. In all cases there is a basic externality at the core of the respective models: liquidity has public good features which liquidity providers cannot fully appropriate. See: Diamond and Dybvig (1983), Holmstrom and Tirole (1998), Diamond and Rajan (2000), and Kahn and Santos (2008). 28 well informed and fully responsible for their investments. As a result, they should monitor adequately the unregulated financial intermediaries, making sure their capital is sufficient to eliminate moral hazard. Consistent with this line‐in‐the‐sand rationale, only deposit‐taking intermediaries are prudentially fully regulated and supervised under the current regulatory architecture. In exchange, and reflecting their systemic importance, they benefit from a safety net. Other financial intermediaries (and all other capital markets players) neither enjoy the safety net nor are burdened by full‐blown prudential norms. Instead, they are mostly (if not only) subject to market discipline, enhanced by well known securities markets regulations focused on transparency, governance, investor protection, market integrity, etc. Interestingly, the early history of regulatory intervention, which was marked by the introduction of the safety net, was more closely linked to externalities than to age...
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