Unformatted text preview: ath on both the way up and the way down, driven by similar incentives and risk management models, further boosted the systemic impact of these externalities. See Brunnermeier (2008). 49 Allen and Gale (2005) discuss the possible implications for systemic risk of such transfers. 46 34 to “internalize” the liquidity and other externalities.50 Instead, their incentive is to play it safe by investing very short and running at the first signal of trouble and to increase leverage by as much as is privately (not socially) optimal. To be sure, reflecting regulatory shortcomings in the internalization of systemic liquidity risk (see below), incentives were not much better aligned for the regulated intermediaries. Nonetheless, capital in the regulated sector substantially exceeded that in the unregulated sector, reflecting systemic concerns of regulators for the commercial banking sector.51 Thus, the side‐by‐side existence of a regulated sector—where systemic concerns were partially factored in—and an unregulated sector—
where externalities were not at all internalized—created a wedge in returns between the two worlds, giving rise to a fundamentally unstable construct. Investors left in droves the regulated intermediaries to join the world of the less regulated, highly leveraged and short funded intermediaries, rapidly raising their relative size and boosting systemic risk in the process. Moreover, because it involved sophisticated and unsophisticated investors, the exodus spread moral hazard throughout the presumably moral‐
hazard free unregulated (or less regulated) world. The resulting competitive pressures on commercial banks ultimately motivated the repeal of the Glass‐
Steagall Act.52 However, by challenging commercial banks to compete head‐on with the blown‐up investment banks and on their turf, the repeal induced the former to find creative ways to shed their regulatory burden outside their balance sheet. Thus, oddly enough, the Glass‐Steagall Act resulted in a one‐two punch on the soundness of financial intermediaries. Its introduction boosted systemic risk outside commercial banking. Once this was done, its repeal boosted systemic risk within it. As in the agency paradigm, supervisors come out severely bruised. They did not realize that their own well‐meaning regulation was setting into motion a deadly process of regulatory arbitrage that shifted intermediation to a field where inducements to internalize externalities were weaker or nonexistent, thereby contributing to asset over‐pricing and spreading liquidity risk all over the financial system. And even when supervisors caught up, they were unable to do much because in the cat‐and‐mouse game of regulatory arbitrage the mouse had trespassed over the line‐in‐the‐sand to a territory where prudential regulation was not unreasonably reluctant to enter. Investment banks, hedge funds, and the like were thus simply left out of reach.53 Moreover, even within the regulated world, the Basel‐inspired wave of prudential regulation focused little on liquidity. And when the norms address...
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