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86the costofoversightwouldremainlow however as the

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Unformatted text preview: e of regulatory collision between the paradigms. 79 The scope for learning is crucial for determining the need for any regulation, not just the safety net. Indeed, a good case can be made that even without a regulatory reform crises should convince principals (shareholders and investors) that they need to improve their control on agents (managers). 80 The remaining question, of course, is whether such a system would be “fair” to the smaller and less educated consumers who might be scared away and remain forever on the fringes but in the end this is likely to be an issue of consumer protection more than systemic stability. 81 Indeed, from a pure moral hazard perspective, the expansion of the safety net (particularly the creation of deposit insurance) can be seen as a mistaken knee‐jerk reaction that has come back to haunt the current regulatory architecture and the goal should be to get rid of it. See for example Herring and Santomero (2000), Gale (2004), and Calomiris (2008). 45 Table 3. The Need for A Safety Net Paradigm Issue Agency Externalities Mood Swings Can players learn on their own? Probably Yes No Apparently not Is an ex‐post LOLR needed? No, it is Counterproductive Yes, to provide systemic liquidity Yes, to absorb systemic risk Is a deposit insurance needed? Probably not Yes, to limit risks of Yes, to limit impact “wrong” runs of mood swings Interestingly, as regards the scope for learning, the mood swings paradigm lies somewhere in the middle. The constantly evolving environment makes some learning possible but tricky. One would think that agents should learn to be more cautious and eventually come to realize that, even if the scope for the truly new is constrained by path dependence, nasty surprises can emerge and that “not all that glitters is gold”. History has amply demonstrated that this is not the case, however. Moreover, learning in this paradigm is somewhat of an oxymoron. Believing that one has finally “learned the lesson” can boost over‐confidence in one’s ability to navigate through the obstacles, thereby setting in motion a mood swings‐induced bubble. The uncertainty conscious supervisor would thus agree with his externalities colleague as to the core importance of the LOLR. However, as already noted, he would expect the LOLR mainly to absorb systemic risk rather than provide liquidity. Similarly, he would agree that a deposit insurance is needed to “calm down” the frayed nerves of investors when moods start to turn ugly. Towards a New Regulatory Framework The discussion in the previous sections suggests that the design of a proper regulatory architecture faces two major challenges.82 The first is to build a regulatory framework that takes into account all three paradigms and avoids solving problems in one paradigm at the cost of making matters sharply worse in another. The second challenge is to find an adequate balance between financial stability and financial development. Extreme solutions—a crisis‐pro...
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