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Unformatted text preview: diaries the choice between becoming regulated (with the same capital adequacy requirements as commercial banks) or remaining unregulated subject to the condition of not funding themselves in the capital markets (in other words, prudentially unregulated intermediaries could only borrow from regulated intermediaries);18 (iii) giving the regulator more powers to authorize innovations and norm instruments; (iv) enabling the supervisor (through appropriate statutory powers, accountability, and tools) to play a more “holistic” role by focusing more on the system (its risks, evolution, links, etc.), and to set and calibrate (within bounds) countercyclical prudential requirements depending on changing circumstances, much as the interest rate is calibrated by monetary authorities; and (v) revisiting the 18 The obvious complement to this approach would be to ensure that all the direct and indirect credit risk exposures (on‐ and off‐balance sheet) of the regulated intermediaries are backed by capital (“skin‐in‐the‐game”), at a level which ensures regulatory neutrality. 25 deposit insurance to incorporate systemic risk, rethinking the LOLR as a risk absorber of last resort, and examining the feasibility of pairing them with a systemic insurance subscribed by all financial intermediaries.19 The rest of the paper is organized as follows. Section 2 goes back to the foundations and pitfalls of intermediary‐based finance and briefly retraces the steps and objectives of modern regulation. Sections 3 to 5 present alternative interpretations of the Subprime crisis from the perspective of each of the three paradigms. Section 6 sums up the main failures of regulation and emphasizes the deep contrasts that exist between the three paradigms when one tries to address these failures. Section 7 concludes by laying down a minimum set of basic objectives that would need to be met in order to ensure a more harmonious integration of the three paradigms. The Foundations of the Current Prudential Framework Finance seeks to bridge three basic gaps (Chart 1). First, there is an information and control gap (a principal‐agent problem) that reflects fund suppliers’ exposure to the idiosyncratic risks and costs involved in properly screening and monitoring fund users, and enforcing contracts with them. Second, there is a price volatility‐uncertainty gap that reflects fund suppliers’ aversion to becoming exposed to aggregate risks (market‐specific or systemic) over which they have no control. Third, there is a liquidity‐
maturity gap that reflects fund suppliers’ “opportunistic” desire to maintain access to their funds and a quick exit option at all times. This third motive responds both to idiosyncratic risks (a quick exit disciplines fund users and mitigates agency problems) and aggregate risks (liquid portfolios and flights to cash mitigate exposure to uncertainty and mood shifts). Reflecting transaction costs and borrower size, the bridging of these gaps t...
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