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Unformatted text preview: ed liquidity issues, they did so from a purely idiosyncratic perspective.54 To his defense, however, the externality‐conscious 50 A similar point was made by Bernanke (2006). For example, investment banks’ leverage of around 25—compared to commercial banks’ leverage of only about 10—gave the former an obvious advantage. Although the SEC, as lead regulator, applied to investment banks the same Basel capital rules as for commercial banks, the differences in leverages resulted from the much lower capital requirements on “trading books” than on “banking books” and the fact that limits on gross leverage ratios only applied to commercial banks. 52 Pushed by the forces of competition and deregulation, commercial and investment banks seemed to have met somewhere in the “regulatory middle”. As the repeal of the Glass‐Steagall Act allowed commercial banks to encroach more directly on investment banks’ traditional fee‐based business, the former took on more fees in order to offset losses in intermediation margins. Also, and partly as a result of the deregulation of commissions for stock trading in the 1970s (that allowed low‐cost brokers to encroach on investment banks’ brokerage activities), self‐
standing investment banks gradually shed their fee‐based business in favor of a highly‐leveraged margin‐based business. See Eichengreen (2008). 53 The move towards consolidated supervision of financial conglomerates was as far as prudential regulators were willing to extend their reach to protect the core banking system from capital market risks. 54 For example, liquidity norms generally advocate minimum ratio of liquid assets to liabilities to limit maturity mismatches. But this is simply not good enough from a systemic viewpoint where even short‐maturity assets can 51 35 supervisor may argue that systemic events such as the Subprime crisis are akin to “one‐hundred year floods”. They are too rare and unpredictable to be usefully internalized in prudential regulations. The social cost of doing so (note here the italics) would simply exceed the social benefits. Hence, a better option is to have a prompt correction regime and an efficient public rescue system. The missing piece in this paradigm, which is otherwise convincing enough, relates to its dynamics. To be sure, the lack of sufficient internalization of systemic risks can lead as easily as moral hazard‐based incentives to a more fragile and vulnerable system. Yet, unlike in the agency case, the externalities paradigm in and of itself lacks inherent dynamics that gradually increase the precariousness of the equilibrium over time and eventually bring the system so close to the edge that the tiniest exogenous shock would throw it over.55 In the pure externalities paradigm, intermediaries continue to “manage” their risk, adjusting it to what is privately optimal and then just staying there. The large shock that eventually sent the financial system over the edge must have therefore come out of “left field”—an exogenous act of god, whose probability was independent of the degree of vulnerability of the system. However, as far a...
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