Worldbankworkingpaper 4807

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Unformatted text preview: nt bankruptcy code (this would allow the less successful intermediaries to exit promptly, thereby maintaining the vitality of the system). The fourth objective relates to the importance of keeping a tighter rein on the possible downstream risks of financial innovation, particularly (but not only) from a mood swings perspective. This would require giving the regulator more powers to regulate, standardize, and authorize all forms of innovation (whether in instruments, institutions, or markets) and to subject them to much more rigorous pre‐ approval and road‐testing, much as in the case of new drugs for the FDA.92 The fifth objective is realigning the respective monitoring roles of markets and supervisors to address the underlying weaknesses of market discipline under both the externalities and mood swings paradigms. Markets can no doubt continue to play an important ex‐ante role in helping align incentives with respect to principal‐agent frictions. However, it would be foolish to expect market discipline to prevent externality‐ or mood swings‐induced systemic crises. Moreover, imposing market discipline ex‐ post, once the system is deeply out of equilibrium and a crisis is unfolding, is fraught with danger.93 By contrast, in the multi‐paradigm world, the supervisor would be naturally expected to have such a tough and complex responsibility that reasonable doubts exist as to whether its implementation lies in the feasible range. Unlike in the pure agency paradigm, he can no longer relax and concentrate on relatively simpler policing tasks once he has put in place the necessary arrangements to promote market discipline (hence, self‐regulation). Instead, the “holistic” supervisor of the mood swings paradigm provides a valuable scouting, moderating, and coordination service to society that markets cannot provide. To this end, he should be able to connect the dots, understand the forest beyond the trees, and 90 The direction towards which incentives need to be aligned (and moods tempered) shifts abruptly depending on the phase of the cycle: the upward phase calls for taking less risk and accumulating capital, the downward phase for taking more risk and using up capital. 91 Additional ways to better internalize systemic liquidity risk might also include limits on gross leverage, an in‐ depth review of the differentiated capital requirements on trading books versus banking books, and some form of liquidity buffer (i.e., a prudential norm encouraging the holding of systemically safe assets). On the latter, see Morris and Shin (2008). 92 A very similar recommendation can be found in Buiter (2008). By the same token, the tight linkages between financial innovation and deregulation also call for special attention to the potentially destabilizing market implications of regulatory reform (unduly exuberance or moral hazard‐induced dynamics). 93 The failure of Lehman Brothers provides a vivid recent illustration of the risks attached to 11th h...
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