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This third motive responds both to idiosyncratic

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Unformatted text preview: rnalities paradigm, as markets of their own cannot close the wedge between private and social costs and benefits, the relevant regulation cannot be “market friendly” and the supervisor’s role becomes more central. Moreover, because of the high cost associated with crisis‐ proofing, the system’s exposure to some tail risk (akin to “one hundred year floods”) is likely to remain. The ex‐ante crowd coordination and control role of the supervisor needs therefore to double up, if a crisis materializes, with an ex‐post fireman role. Finally, in the pure mood swings paradigm there are no incentive distortions but market participants cannot fully visualize the dynamic and systemic risk implications of market completion and innovation. Hence, markets are unlikely to provide efficient pricing signals. Unless effective safeguards can be put into place, this severely undermines the Basel II‐type, risk‐based regulatory architecture where every risk can presumably be assessed and translated into an efficient prudential norm. By the same token, the mood swings paradigm boosts the role (and responsibility) of the supervisor, who has to become a scout and a moderator, constantly looking for possible systemic trouble ahead and slowing down the system when uncertainty becomes too large. To be successful, any reform of prudential regulation will need to integrate the key insights and sidestep the main pitfalls of all three paradigms in a way that limits inconsistencies and maintains a proper balance between financial stability and financial development. Overcoming these tensions will require a dialogue between researchers and policy makers whose perception of the world may be colored by different paradigms. One of the aims of this paper is to contribute to this dialogue. The paper also proposes a set of basic objectives that any regulatory reform should seek to fulfill in a multi‐paradigm world. Reflecting the main current pitfall of un‐internalized externalities, the reform will need to improve the alignment of incentives by internalizing (at least partially) systemic liquidity risk, thereby lessening the likelihood of crises. However, it should do so in a way that ensures regulatory neutrality and leaves room for prudentially unregulated intermediaries to enter and innovation to thrive. At the same time, reflecting the pitfalls of uncertainty and mood swings, the reform will also need to pay more attention to the risks of financial innovation and rebalance the monitoring roles of markets and supervisors, with the latter acquiring more responsibilities but also more powers. Since in a world of externalities and uncertainty‐driven mood swings even the best regulation and supervision are unlikely to fully eliminate the risk of systemic crises, improving the systemic features of the safety net will continue to be an essential objective. Consistent with these objectives, we propose: (i) making prudential norms also a function of the maturity structure of the intermediary’s liabilities; (ii) giving prudentially unregulated interme...
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