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Unformatted text preview: ould add up to systemic risk protection. Yet, markets for individual risk protection instruments could only continue functioning if some intermediary was willing to continue “making the market”.47 The extreme systemic fragility of such interconnectedness has by now become obvious.48 By unloading (selling) risk—for example through credit default swaps—to other financial institutions such as insurance companies, intermediaries further intensified the negative systemic externalities.49 Such transactions might have reduced the exposure of institutions individually but increased the exposure of the system as a whole. Yet, this move was openly encouraged by regulators (insured assets had a low or zero risk weight), who viewed it as a way to reinforce market discipline (again, an example where moral hazard and externality containment directly collided). The possible systemic costs of trading credit derivatives over the counter (without a central clearing counterparty or protocols for multilateral netting), rather than on an exchange, were not internalized either. While the fragility brought about by externalities has received much attention in the crisis literature, an equally important consequence of un‐internalized externalities that has received much less attention is their implication for regulatory arbitrage. As in the case of moral hazard, the growth of shadow banking can also be explained as externality‐induced incentives to circumvent regulation. The key difference is one of intent. From an externality viewpoint, intermediaries were “doing nothing wrong” by finding new ways to take on more risk. Instead of seeking to take one‐sided bets with someone else’s money, as in the agency paradigm, the intermediaries engaged in regulatory arbitrage under the externalities parading were just searching for ways to match more closely their risk taking with their risk appetite, and they were doing so in a way which, from their own (limited) perspective, was sufficiently safe. From their individual viewpoint, regulations were “unnecessarily binding”. In this sense, the intent of the Glass‐Steagall Act—to shift risk away from regulated intermediaries to capital markets and unregulated intermediaries—was fundamentally misguided. While it could have solved the agency problem (by shifting risks to the land of the well informed) if it had been done cleanly enough (i.e., without dragging the banking system into the mud and the safety net over the line‐in‐the‐
sand), it exacerbated the externalities problem. Well‐informed investors can monitor the intermediaries to make sure they do not “cheat them” (play the moral hazard card). However, they have no incentives 45 See Greenlaw et al. (2008), Adrian and Shin (2007 and 2008), and Brunnermeier (2008). Yet, there were no capital charges for such “reputational” credit lines (see Brunnermeier, 2008). 47 The linkages between securities market liquidity and funding liquidity, and the resulting increased scope for liquidity spirals are analyzed by Brunnermeier and Pedersen (2008). 48 The fact that most intermediaries traveled along the same p...
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