Moreoverbecauseitinvolvedsophisticated and

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Unformatted text preview: ightening regulation in isolation has a high cost, as business will quickly flow to the less regulated sectors or countries. The lack of sufficient buffers was indeed at the core of the severity of the collapse. As in the case of traditional banking, shadow banking was financed mostly through short‐term obligations (and largely perceived to be redeemable at par), much of it through overnight repos. The potential for a bank‐type run was therefore there from the outset. But two additional factors made for a much more explosive situation. First, the financing came mainly from ready‐to‐run wholesale investors, thereby introducing a new, more unstable layer to the intermediation process. Second, the capital and liquidity buffers held by most shadow‐banking intermediaries to protect their short‐term liabilities from price fluctuations in the final asset (housing) were much smaller than in traditional commercial banking. This reflected the high leverage of self‐standing investment banks and (to a less extent) hedge funds, as well as the lack of capital put in by the final borrowers who benefited from high loan‐to‐value ratios and second mortgages. Thus, as documented elsewhere in detail, once a tail‐risk event materialized and pressures 43 See for example Gorton (2008). Because individual agents do not internalize the general equilibrium impact on asset prices of fire sales under financial distress, they can bid up the price of these assets in excess of their socially optimal value. Lorenzoni (2007) develops a model along these lines and shows that competitive financial contracts can result in excessive borrowing ex‐ante and excessive volatility ex‐post. As in Holmstrom and Tirole (1998), agents cannot insure themselves against aggregate liquidity shocks due to a limited ability to commit to future repayments (this in turn reflects agency frictions). Korinek (2008) develops a paper along the same lines but applied to capital flows rather than domestic intermediation (in his model, agents borrow too much because they do not internalize the potential impact of an exchange rate move on a systemically‐induced need for sudden repayment). 44 33 to sell started to build up, the devastating downward spiral quickly dried up liquidity and brought markets to a standstill.45 In the shadow banking world, the externality pitfall of traditional banking operated with a vengeance, as everyone counted on everyone else’s for support but no one adequately internalized the systemic risks of such cross‐support. Investment banks counted on commercial banks (both for liquidity and for asset repurchases);46 commercial banks counted on market liquidity (why hold liquid backing against assets which you can sell at any time in the market place?); and leveraged intermediaries counted on credit default swaps and other forms of insurance issued by other leveraged institutions. In the process, a great fallacy of composition developed—leading market players (and supervisors) wrongly to believe that risk protections at the individual level w...
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This document was uploaded on 11/14/2013.

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