The process was exacerbated by the lack of fair value

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Unformatted text preview: ncy problems. However, subsequent regulatory developments came to be dominated by concerns about principal‐agent frictions, particularly moral hazard, which the safety net itself exacerbated. But at this point the logic of the line‐in the‐sand completely missed the obvious facts that, even if free markets take care of principal‐agent problems, they will (nearly by definition) neither internalize externalities nor temper mood swings and price risk appropriately where genuine uncertainty exists. Thus, the regulatory architecture that is in place today became seriously unbalanced.25 In fact, the line‐in‐the‐sand became porous and was widely breached during the build‐up to the Subprime crisis, as highly‐leveraged intermediation developed outside the confines of traditional banking—in what has now become known as the world of “shadow‐banking”—and the safety net had to be eventually sharply expanded, from the regulated to the unregulated.26 The explosive growth of “shadow banking”—driven by the originate‐to‐distribute model, which relied on the securitization of credit risk, off‐balance sheet transactions and vehicles, and fast expansion highly‐leveraged intermediation by investment banks, insurance companies, and hedge funds—has been so well documented elsewhere that it is not necessary to reiterate the details here.27 It is only worth stressing that, by radically expanding the interface between markets and intermediaries, the process brought a variety of new problems and issues. However, the same underlying pitfalls of agency problems, liquidity runs, and mood‐driven cycles reappeared with a vengeance. In what follows, we interpret the story behind this shift to “shadow banking”—its roots, dynamics, and implications—from the vantage point of each of the three paradigms. As many of the observed features of the Subprime crisis can be consistent with more than one of the three paradigms, attribution is inherently problematic and conclusive proofs are virtually impossible. Hence, the strategy is to work out the internal logic of each paradigm taken by itself, so as to illustrate its potential explanatory power as well as highlight its internal limitations. We will also refer to structural factors such as financial innovation, competition, and regulatory arbitrage when useful to illustrate the inner workings of a particular paradigm, albeit such factors affect all paradigms. On the other hand, although we certainly 25 In modern terms, the prudential framework can be seen as a “line of defense” or “buffer” that partially shields public funds from bank losses by reinforcing market discipline and putting a positive price on the safety net. While focusing on capital, the existing prudential framework clearly goes beyond capital—it includes liquidity requirements, loan‐loss provisioning, fit and proper rules, loan concentration limits, prompt corrective actions, bank failure resolution procedures, etc. 26 Key players in the Subprime m...
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