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Unformatted text preview: eltdown included commercial banks (the prototypical financial intermediaries) and other intermediaries that blossomed outside the banking system and became hyper‐leveraged (mainly investment banks but also insurance companies, hedge funds, as well as commercial banks themselves trespassing into securities markets through off‐balance sheet special investment vehicles—SIVs). 27 See for example Adrian and Shin (2008), Brunnermeier (2008), Gorton (2008), and Greenlaw et al. (2008). 29 recognize the importance of macroeconomic impulses such as the savings glut (and related macroeconomic imbalances) and the “Greenspan factor” (the long period of low interest rates), we restrict our attention to prudential failures because they are the ones that matter for regulatory reform. The Agency Paradigm The moral hazard‐agency story of the Subprime crisis is arguably the most popular.28 It posits that incentive distortions arising from unchecked principal‐agent problems (the heads‐I‐win‐tails‐you‐lose syndrome) are the source of trouble, inducing market participants to either pass on risks deceptively to the less informed or take on too much risk themselves with the expectation of capturing the upside or exiting on time and leaving the downside with someone else. The perversion of incentives can happen at one or several points of the credit chain between the borrower and ultimate investor, passing through the various intermediate links. However, for moral hazard to start driving the show, it must be the case that the expected upside benefits come to dominate the expected downside costs (i.e., losing one’s capital or reputation). This can occur under two plausible scenarios: (i) an innovation (perhaps facilitated by deregulation) opens a world of new opportunities (the upside widens), or (ii) a macro systemic shock suddenly wipes out a large part of the intermediaries’ capital (the downside shrinks).29 Indeed, one can argue that in the case of the Subprime crisis it was the discovery of new instruments and intermediation schemes (securitization and shadow‐banking) which set the process in motion.30 The expansion of upside opportunities led to a moral hazard‐induced under‐pricing of risk, encouraging participants to make the bet and take the plunge.31 This process, which Basel I regulation encouraged, can be explained in part by regulatory arbitrage.32 However, poor regulation (that did not sufficiently align the incentives of principals and agents, whether the risk was acquired off or on balance sheet) can no doubt also be blamed. Indeed, the build‐up phase of the crisis provided plenty of opportunities for all sorts of principal‐agent problems to expand and deepen. The multiplication of actors (borrowers, loan originators, servicers, securitization arrangers, rating agencies, asset managers, final investors) involved in the originate‐to‐ distribute model not only reflected the increased sophistication and complexity of intermediation but also boosted the scope for accompanying frictions, including moral hazard, but also predatory lending, 28 See for example Caprio et al. (2008) and Calomiris (2008). The sudden o...
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