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79 the scope for learning is crucial for determining

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Unformatted text preview: t valuations, crumbles. This aspiration presupposes that risk dominates uncertainty and markets are efficient, two premises that an unbridled mood swings paradigm debunks.78 The only scope for markets to play a role in the mood swings paradigm would be taking bets on whether the system as a whole is headed in the right direction or likely to crash. While dedicated and well trained observers may well be able to detect an incoming iceberg through the fog, grasping how the system is wired and understanding the possible cracks is likely to require hefty investments and sophisticated skills. Hence, “systemic risk gazing” is unlikely to be a profitable market activity and should be viewed instead as a public good. Upgrading the role of the supervisor to provide such “holistic supervision” should therefore become a key component of reform. However, as discussed below, this will require, in addition to sound judgment and vision, sufficient independence and accountability—a tall order indeed. Consider next some of the key implications for the nature of prudential regulation. As regards the scope of regulation (the “line in the sand”), the discrepancies between the three sides are obvious. A supervisor grounded in the agency paradigm would insist that allowing unregulated intermediaries to operate freely is the proper thing to do. Informed investors will naturally migrate to the unregulated world where innovation can thrive, risks and returns will likely be higher, and—as long as information is timely and reliable—users of funds will be appropriately disciplined. However, for the reasons already noted above, his externalities colleague would be dead set against the idea of allowing prudentially unregulated intermediaries to operate side by side with the regulated sector. The mood swings supervisor would be of a more mixed mind. Unregulated intermediaries could make his life more difficult as uncontrolled innovation, pushed along by the forces of competition and regulatory arbitrage, could set eventually the system on the wrong track. However, provided all innovation is regulated, he might find this to be manageable. As regards the focus of regulation, the discrepancies across paradigms as regards the scope for market discipline have profound implications for the way risk is both reported and managed. Consider accounting issues first. In the agency paradigm, fair value accounting is clearly the superior alternative. Ensuring that changes in market values are immediately reflected in balance sheets is essential to contain the risk of a moral hazard‐driven bubble where undercapitalized intermediaries are allowed to 76 However, as proposed by Kashyap, Rajan, and Stein (2008), it might be feasible to set up private partial insurance schemes in the form of additional capital becoming available under stressful systemic events. 77 See Danielsson and Shin (2002). 78 De Grauwe (2008) makes a similar point. 43 continue operating normally. However, fair value accounting can be problematic under the other two paradigms. By enhancing the impact of one intermediary’s...
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