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Unformatted text preview: reated a bias in favor of unregulated intermediaries that drew in unsophisticated investors in droves and made them grow explosively. In turn, this competitive bias induced banks to elude regulation by pushing risk outside their balance sheet and turn a somewhat blind eye to the risks taken by their borrowers. Thus, not only was risk not adequately internalized ex‐ante but also prudentially unregulated (or less regulated) intermediaries quickly grew to the point where they became systemically relevant players and, hence, had to be admitted ex‐post to the safety net, no questions asked. Consider next the failures of focus. First, the prevailing regulatory framework established a neatly dividing line between the ex‐ante prudential norms and the ex‐post safety net. The ex‐ante regulatory framework focused on maintaining the soundness of assets, the ex‐post safety net on maintaining the liquidity of liabilities. The obvious loose end was the lack of ex‐ante internalization of systemic liquidity risk. Second, prudential regulation focused on the soundness of each institution under the assumption that the sum of sound institutions was equivalent to a sound system. However, as noted earlier, the Subprime crisis showed that this approach constituted a major fallacy of composition. It turned instead the approach on its head: the system is what matters most to the soundness of each institution.72 Third, traditional regulation focused on statistically observable risks and made much out of the sophisticated and complex risk modeling techniques that fed on these statistics. Yet, the Subprime crisis 72 Basel‐style regulation rewarded those institutions that covered their risks with products and services offered by other institutions. Yet, the Subprime crisis showed those atomized protections to be not only irrelevant (they provided a false sense of security, unraveling when most needed) but possibly counterproductive as well (they exacerbated contagion and the risk of overall systemic failure). 40 demonstrated that what you do not see is what will kill you (tail risks, black swans, and endogenous risk).73 Finally, consider the failures of dynamics. Basel‐style regulation was essentially static. Norms were time invariant (cycle independent) and the mandated capital buffers were assumed to be sufficient to carry the system through the business cycle.74 The Subprime crisis proved that approach wrong: static norms turned out to be pro‐cyclical, too loose on the way up, too tight on the way down. Last but not least, Basel‐style regulation failed to adequately incorporate the dynamic links between monetary and prudential policies. The central bank’s job adhered to ensuring macro stability and providing lender‐of‐
last‐resort services, the supervisor’s to ensure financial prudency, and the two did not need to interact much. Yet, the insufficient attention of monetary authorities to the implications of their actions on financial developments, coupled with the insufficient attention of the supervisors to macro dynamics, deeply contributed to the crisis.75 A major problem when seeking to address these regulatory failures is that the best fix will most often depend on the paradigm. How one sees reform is thus essentially a function of the lens one uses. Table 2 synthesizes t...
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