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Interestingly the early history of regulatory

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Unformatted text preview: map all three gaps and paradigms portrayed in this paper. While we will describe these failures more fully in each of the three subsequent sections, a brief preview here will help establish the historic setting and rationale for the current regulatory framework. Principal‐agent problems give rise to a variety of malfeasance manifestations, most importantly moral hazard.21 Should all depositors be well informed, banks could eliminate moral hazard to the satisfaction 21 The list of malfeasance manifestations with which bankers and other financial intermediaries have been associated over the ages also includes adverse selection, predatory lending, outright fraud and pyramid schemes (Ponzi finance). In this paper, we will broadly lump together all forms of malfeasance within the agency paradigm 27 of depositors by holding capital.22 But the mix of small uninformed depositors and larger, better informed investors can lead to inefficient equilibria in which banks and wholesale investors benefit at the expense of the retail depositors (or their deposit insurance).23 Governance issues compound the problem by superposing additional layers of moral hazard. In particular, bank managers may take decisions that benefit them in the upside but leave the downside mostly to the shareholders or investors. The opportunistic behavior of fund suppliers or intermediaries faces an externalities problem. Financial intermediaries are exposed to runs by their depositors or lenders, triggered by self‐fulfilling panics or suspicions of intermediary insolvency. Even if they could limit this risk by holding sufficient capital and liquidity, their incentive to do so is limited by the fact that they do not internalize the social costs of a run, i.e., by the existence of externalities.24 The attitude of financial intermediaries (as well as that of other agents) towards price volatility also gives rise to a market failure in that their decisions in the face of uncertainty are influenced by mood swings. They incur bouts of excessive optimism (exuberance) during the upwards phase of financial expansions and excessive pessimism (extreme uncertainty aversion) during contractions. In either case, this compounds price volatility and can lead to sharp deviations from underlying fundamentals (bubbles). Regulation has been designed to help intermediaries overcome the two first pitfalls, albeit not the third. The current regime rests on three key pillars: (i) prudential norms that seek to align incentives ex‐ante; (ii) an ex‐post safety net (deposit insurance and lender‐of‐last‐resort) aimed at enticing small depositors to join the banking system and forestalling contagious runs on otherwise solvent institutions; and (iii) a “line‐in‐the‐sand” separating the world of the prudentially regulated (mainly commercial banking) from that of the unregulated. In turn, the line‐in‐the‐sand rests on at least three key arguments. First, regulation is costly and can produce unintended distortions. It can limit innovation and competition, and it needs to be accompanied by good, hence inherently costly, supervision. Second, extending bad oversight (oversight on the cheap) beyond commercial banking can exacerbate moral hazard—it can give poorly regulated intermediaries an undeserved “quality” label (hence an edge in the market place) and an...
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