Looking ahead regulatory reform is largely

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Unformatted text preview: n trigger was the rise in deposit rates that accompanied the increase in inflation of the late 1970s and the subsequent, sharp tightening of monetary policy. For the Subprime crisis, the trigger was the decline in housing prices. In all three cases, the crisis resulted from a rapidly rising wedge between the underlying value of financial intermediaries’ assets and liabilities, which prevented them from honoring the implicit insurance commitments they had made to their clients. High leverage and liquidity on demand, which limited the size of the buffers available against shocks, made these wedges lethal. While the proximate triggers of these crises are fairly clear, the most interesting question is why financial intermediaries continue to contract such huge implicit insurance commitments while failing recurrently at honoring them, in the U.S. or elsewhere. Going back to the fundamentals of financial decision making, three possible explanations spring to mind: (i) managers of financial institutions understood the risks they were taking but made the bet because they thought they could capture the upside windfalls and leave the downside risks to others (the agency paradigm); (ii) managers understood the risks they were taking, yet went ahead because they did not internalize the social risks * World Bank Policy Research Working Paper 4842 17 Throughout this paper we use the term “Subprime crisis” to denote the current, broader crisis of structured securitization and its propagation across financial markets and borders. 2 3 and costs of their actions (the externalities paradigm); and (iii) managers did not fully understand the risks they were running into; instead, they reacted emotionally to a constantly evolving, uncertain world of rapid financial innovation, with an excess of optimism on the way up and, once unexpected icebergs were spotted on the path, a gripping fear of the unknown on the way down (the mood swings paradigm). These three paradigms reflect human condition in a nutshell. In the agency paradigm, the better informed are constantly tempted to take advantage of the less informed and, ultimately, the state. By contrast, in the externalities paradigm, financial intermediaries are free agents whose decisions do not necessarily coincide with the public good, or in the case of group coordination failures, with their own good. In the mood swings paradigm, like all market participants, managers of financial institutions have bounded capacity to deal with the genuine uncertainty lying ahead, which is naturally associated with bouts of risk euphoria (“this time around, things are really under control…”) followed by episodes of sudden alarm and deep risk retrenchment. The next question that naturally comes to mind is why such similarly triggered crises have continued to recur notwithstanding the development over the last eighty years or so of a formidable set of prudential regulations precisely designed to prevent systemic failures. Not only has regulation failed abysmally but attempts to seek a safer regulatory path ahead seem in some cases to have made matters subsequ...
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