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Unformatted text preview: pening of profitable new business opportunities that set the cycle’s upswing into motion is what Fisher (1933) called a “displacement”. 30 By contrast, the S&L crisis can be viewed as driven by deregulation and the rise in interest rates that effectively de‐capitalized the system (a reduction of downside risks), unleashing the subsequent rounds of “betting for survival”. The process was exacerbated by the lack of fair value accounting (which aggravated information asymmetry problems while allowing insolvent institutions to continue operating normally) and generous regulatory forbearance. 31 There is a body of literature emphasizing moral hazard‐caused deviations of asset prices from their fundamental values. See for example Allen and Gale (1998). While these deviations may be interpreted as “bubbles”, the underlying models are typically static. 32 Basel I prudential standards encouraged securitization through differential risk weights (a mortgage held on a bank’s balance sheet is charged with a 50 percent risk weight, against only 20 percent if securitized). At the same time, although Basel I did incorporate some off‐balance sheet commitments, conversion factors limited their impact on capital. Banks could also circumvent regulation through innovations such as tranching and indirect credit enhancements, the use of the trading book rather than the banking book, and other balance sheet adjustments. See Tarullo (2008). 29 30 mortgage fraud, adverse selection, and other principal‐agent problems.33 The widespread preference of unregulated intermediaries to lever up on the basis of mainly short‐term funds can also be interpreted as driven by moral hazard. Managers (at least some of them and particularly, but not only, asset managers) also seemed to have danced eagerly to the moral hazard tune. While enjoying the high returns of the good times, they let their shareholders and investors deal with the losses in the bad times under the convenient excuse that everybody shared the same miseries.34 A good case can also be made that the state promoted moral hazard on the way up. Some argue, for example, that the widespread subsidies and guarantees provided to the house financing sector in an effort to boost access (exacerbated by Fannie Mae’s and Freddie Mac’s “quasi‐mandated” foray into the sub‐prime sector) can be blamed for launching the ball and boosting its moral hazard momentum once in play.35 The failure to control the build‐up phase can then be attributed to the regulator’s inability to win the cat‐and‐mouse game of regulatory arbitrage. Banks managed to stay on top by swiftly moving to the shadow‐banking world, with regulators hardly able to keep up.36 The extreme fragmentation and overlapping mandates of agencies that comprise the U.S. supervisory system was of course the final blow. Had the regulators been aware and statutorily able to do something, the necessary coordination was just too much to handle...
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