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Thereishoweveraminimumsetofbasic objectives that in

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Unformatted text preview: actions on the balance sheets of other intermediaries, it exacerbates externalities. At the same time, and perhaps more importantly, it magnifies the impact of liquidity or mood swing‐induced deviations in asset prices from their longer run fundamentals. Consider risk management issues next. Are systemic liquidity norms needed? Clearly “no” under moral hazard (this is not a relevant problem), “perhaps” under externalities (as long as the ex‐ante social benefits exceed the ex‐ante social costs), and “probably yes” under mood swings. In the latter case, because crises are endogenous events rather than acts of god, they are likely to be more recurrent. Hence, unless the supervisor is convinced that he will be able to always navigate the ship around the icebergs, taking the proper systemic precautions is a good idea (multiple layers of steel against water inroads will better protect the keel). How important is it to look at the system as a whole? In the agency case, this is not the proper way to look at the problem. Systemic events arise from individual malfeasance and this is where the emphasis should stay. Instead, in the externalities paradigm, a systemic perspective is naturally called for. Indeed, this is exactly what one does when one “internalizes the externalities”. In the mood swings paradigm, the focus on the whole is perhaps even more fundamental. Crises are manifestations of collective excesses and it is impossible to understand the dynamics of the whole by summing up the idiosyncratic risks and dynamic paths of individual institutions. In this context, the answer to the question “how tightly should the prudential and monetary authorities coordinate?” is rather self‐evident. In the agency case, not much coordination is needed. Instead, the Greenspan doctrine seems to apply: let the prudential authority make sure that incentives are properly aligned and the monetary authorities make sure that the ship is sailing at the proper speed (i.e., take care of the cycle). In the externalities paradigm, the two authorities should instead closely consult each other to make sure that intermediaries are not unduly vulnerable to tail‐risk events and that the supervisor is sufficiently aware of where the cycle might go. In the mood swings paradigm, there should be very tight coordination between the two authorities and possibly even no major differentiation between them. By contributing to mood swings, monetary policy becomes an integral part of the prudential story. And the prudential risks ahead become a key dimension of monetary policy decision making. Hence, prudential and monetary adjustments are joined at the hip. Along similar lines, are macro‐prudential, dynamically adjusted norms needed? In the stationary moral hazard world, the answer is clearly negative. Instead, in the externalities paradigm, the exposure to exogenous shocks and fluctuations provides a good basis for cycle‐adjusted norms because it allows prudential buffers to be real buffers, i.e., to be built up during the go...
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