Sinceina world of externalities and uncertaintydriven

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Unformatted text preview: ently worse. For example, a key piece of regulatory legislation coming out of the Great Depression was the Glass‐Steagall Act that sought to shield commercial banks from stock market price fluctuations by barring them from investment banking. In turn, the S&L crisis launched the regulatory push towards securitization as a way to pass on to markets much of the risk associated with housing and other longer term finance. Yet, investment banks and securitization are precisely two ingredients at the epicenter of the Subprime crisis. This paper argues that the failure of regulation largely resulted from a piecemeal approach to reform that looked at one paradigm at a time. In trying to address the central problem under one paradigm, they made the problems under the others worse. Thus, the creation of the Federal Reserve System in 1914 and introduction of deposit insurance after the Great Depression, which set the stage for the public lender‐of‐last‐resort function and were meant to alleviate the instability resulting from recurring runs on the banking system (a problem of externalities), exacerbated the agency‐moral hazard problem. In turn, the strengthening of prudential norms after the S&L crisis, meant to address the acute moral hazard manifestations observed during that crisis, indirectly exacerbated the externalities problem—it drove much of the intermediation outside the prudentially more tightly regulated sphere of commercial banking; once there, participants had less incentives (regulatory‐induced or otherwise) to internalize the externality and hold systemic buffers (liquidity or capital). This last problem of course came back to haunt us in the Subprime crisis. Moreover, while following this game of tag and run between moral hazard and externalities, regulation missed all along another central suspect: asset bubbles growing and bursting under the impact of rapidly shifting animal spirits. In the Great Depression, the bubble and crash were driven by stock prices; in the Subprime crisis, they were driven by housing prices and the weaknesses of subprime mortgage lending suddenly emerging from the fog. To reconcile theory and facts, the third, missing (or much less developed) paradigm—which puts Knightian uncertainty and the associated mood swings (more than incentive misalignments) at center stage—needs to be recognized and dealt with. Looking ahead, regulatory reform is largely complicated by the fact that the internal logic of each of the three paradigms leads to different and often inconsistent regulatory implications. In the pure agency paradigm, the only task of the regulator is to mitigate principal‐agent problems by fostering market discipline—mainly through the disclosure of ample, reliable information and by ensuring that financial 24 intermediaries’ “skin in the game” is sufficient to maintain their incentives aligned in the right direction. A properly set regulatory framework should thus eliminate the risk of systemic crises. By contrast, in the pure exte...
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