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77 seedanielssonandshin2002 78

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Unformatted text preview: his discussion. The first questions in the table (under “foundations”) refer to the objectives of regulation. Although both the aims (reducing principal‐agent frictions or internalizing social costs) and the means (see below) differ, the need to align incentives through ex‐ante prudential norms is clear and uncontroversial under either the agency paradigm or the externalities paradigm. Instead, in the mood swings paradigm, the aim is to maintain innovation under control and to temper mood swings. While there is no obvious inconsistency between the two, aligning incentives and tempering moods are nonetheless clearly of a different nature. In either case, the key question as regards the respective roles of markets and supervisors in achieving the mentioned objectives of regulation is whether risk can be priced (which in turn largely depends on whether systemic crises can be avoided). The answer is “yes” in the agency paradigm. Anyone who has enough “skin” invested in his own game will have incentives to maintain risk taking within socially acceptable bounds. Similarly, anyone with enough skin invested in somebody else’s game (and this can also be mandated by regulation) will have an incentive to look for the earliest signs of malfeasance. Markets can thus deliver efficient signals and function as early smoke detectors. Once principal‐agent problems are kept under control, systemic crises should not occur and historical statistics can become the bread‐and‐butter of day‐to‐day micro‐prudential risk management (i.e., help price risk across borrowers, institutions, and instruments). Accordingly, the main role of the agency supervisor is to put in place the necessary apparatus for markets to conduct their monitoring role effectively. Once this is done, his only residual role is one of compliance checking and crime policing (misrepresentation, fraud, looting, etc.). 73 While the regulatory framework has attempted to reduce the gap between risk and regulation (by upgrading from Basel I to Basel II), the Subprime crisis has brought into evidence severe issues of opacity, excessive complexity, and a misleading sense of control. See Tarullo (2008). 74 Spanish regulators were the only ones in the developed world that explicitly dealt with cyclical dynamics by introducing the so‐called “statistical provisions”—i.e., provisions that are built out of income during the upswing of the credit cycle and can be converted into specific provisions in the downward part of the cycle. This commendable approach was never embraced as part of the Basel creed, however. 75 Borio (2003), Goodhart et al. (2004), Rajan (2005), and White (2006) were among the few providing early forewarnings of the dangers of this approach. 41 Table 2. A Synthetic Overview of Regulatory Issues and General Policy Responses Dimensions Paradigm Externalities Mood Swings Betting with someone’s else money Opportunistic behavior that conflicts with the social good Mood swings in an uncertain, evolving world What should ex‐ante prudential norms do? Align incentives through skin in the game Align incentives through internalizing externalities...
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