However by questioning the uniformity of market

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Unformatted text preview: s one can see, there was no such shock in the case of the Subprime crisis. One could argue that, instead of an exogenous shock, the engine driving the financial system to its eventual collapse was a real sector‐driven business cycle. However, prudential norms are supposedly designed to allow financial systems to navigate unscathed through the ups and downs of the regular business cycle. Hence, this could only be a satisfactory explanation if the magnitude of the downturn was unprecedented and truly unexpected. Again, however, this does not seem likely. The financial crisis was unleashed in full force much before there was a marked real sector decline, with causality going mostly in the opposite direction. Alternatively, one could tease out some endogenous dynamics within the externalities paradigm by associating the externalities driving the system to a prisoner’s dilemma. What market participants do individually (i.e., join the feast in the boom and the stampede in the bust) is clearly harmful to themselves and the group, but each participant would stop only if everyone else in the group did the same. That this type of coordination failure can generate some cyclical fluctuation stands to reason.56 That it can lead to a catastrophic and expected systemic collapse is more difficult to accept. In the absence of a non‐externalities related factor—either moral hazard (perhaps boosted by managers’ short incentive horizon) or a truly unexpected unfolding of events (a much bigger or much sooner meltdown than anyone could reasonably have expected)—one would think that at some point the downside risk to each individual participant of remaining in the game should dominate the upside risk. At that point, self‐ preservation should de facto force coordination, keeping the group some distance away from the edge of the cliff. become illiquid. Norms have failed to focus on systemic rollover risk, which is at the core of intermediaries’ vulnerability to runs. 55 Some recent analysis of the unfolding of the Subprime crisis stresses the extreme market fragility resulting from an unexpected market realignment in a context where all the large traders have similar underlying risk models and objectives (Khandani and Lo, 2008). However, it is not obvious that traders would have continued to operate so close to the edge if they had understood the true fragility of the environment in which they were operating and the huge potential costs of a meltdown. 56 For example, Abreu and Brunnermeier (2003) develop a model in which asset bubbles persist despite the presence of rational arbitrageurs because the latter cannot temporarily coordinate their selling strategies due to a dispersion of opinions. 36 The Mood Swings Paradigm The starting point of the mood swings paradigm is the endogeneity of financial innovation within a broad process of financial development. The shift from traditional banking to shadow banking can be interpreted as the natural evolution of a rapidly...
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This document was uploaded on 11/14/2013.

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