As in the case of moral hazard the growth of shadow

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Unformatted text preview: ed by the regulators as regards the growth of the unregulated sector, enforcement costs are not really consistent with the lengthy gestation of the build‐up to the crisis nor with the short‐term nature of the financing that supported that build‐up. A better case can perhaps be made for the intensification of information asymmetry resulting from the opacity, complexity, and 39 Curiously, while deposit insurance fully protected the small depositor, much less was done to protect the small borrower (that has been an important asymmetry as regards consumer protection). 40 Rajan (2005) presents evidence that suggests some increase in overall banking risk, as indicators of banks’ distance to default have not risen in many developed countries and bank earnings variability has not fallen in the United States. Instead, the risk premium implicit in bank stocks appears to have risen. 41 See for example Ambrose et al. (2005). 42 See Brunnermeier (2008). 32 interconnectedness of the new age housing finance market.43 Arguably, this could have provided a cover under which the ones at the top of the pack could have hidden their operations. Yet, it still remains hard to fathom that this “scam” would take place for such a long period, during which the asymmetry between those who were “in” and those who were “out” would linger unabated, and that this would happen in a market place where tips, news, and information are produced by the ton every minute. The Externalities Paradigm Externalities, the mirror image of individual opportunism, clearly play a major role in the collapsing phase of any crisis. Seeking to save oneself by running for the exits puts the others at increased risk of a major meltdown with extreme social costs, thereby exacerbating the violence of the downturn. But externalities also play a key role during the build up stage, making the system inherently more fragile. The failure to internalize the costs of a systemic crisis is at the core of the insufficient demand for prudential buffers, including in particular liquidity, which has features of a public good. Externalities can also induce bubble‐type deviations of asset prices from their fundamentals.44 They can also result in under‐production of information and monitoring (free‐riding) and over‐extension of credit during upswings, over‐contraction during downswings (in both cases, the marginal lender can “sour the market”, increasing the vulnerability of other lenders to a default). Last but not least, coordination failures (a form of un‐internalized externalities) can also play an important role in lengthening and aggravating the upwards phase of the cycle. Market participants may know it is in their best interest to prevent an asset bubble yet fail to do so because doing the right thing would only be optimal if everybody else in the group did it too. Supervisors, both across agencies and across countries, are similarly vulnerable to such coordination failures. For example, t...
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