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Unformatted text preview: Temper moods and domesticate creativity Yes Probably not fully (one hundred year floods) Probably not (unless Moses‐
like supervisor) How effective is market discipline? Potentially very effective Ineffective (inability to estimate or withstand systemic risk) Ineffective (inability to comprehend or withstand systemic risk) What is the role of the supervisor? Enhancer of market discipline‐ crime police Crowd manager‐
fireman Should the line in the sand be redefined? No Yes Not necessarily Yes, it is fundamental No, it exacerbates externalities No, it exacerbates mood swings No Perhaps Yes Probably Yes How important to look at the system? Scope Agency What is the main problem? Foundations Issue Not important Very important Fundamental Should prudential and monetary authorities coordinate? Yes, but not tightly Tightly Very tightly No Yes, rule‐based Yes, judgment‐
based Can risk be priced? Does fair value accounting help? Focus Dynamics Are systemic liquidity norms needed? Are dynamic, macro‐
prudential norms needed? By contrast, the scope for market help is marginal at best in the externalities paradigm, where the key dimension of risk is dynamic rather than cross sectional. It is likely to be socially too expensive to put in place fully crisis‐proof prudential buffers. If so, risks of one hundred year floods (truly extraordinary events) will persist and markets can only help internalize externalities (i.e., provide systemic insurance) if they are able to calibrate the risks and costs of such events, and to withstand their strains. Neither is likely, however. For one thing, tail risks are unlikely to be estimated with precision, even when a 42 sufficiently long statistical history is available. For another, given the contrast between the huge scale of a systemic crisis and its low probability, this is an aggravated case of catastrophe insurance. In view of the difficulties that the latter has faced, it is dubious that full‐blown, market‐based systemic insurance will see the light of day any time soon.76 The scope for market assistance is limited even further in the mood swings paradigm. As in the externalities paradigm, risk is systemic and dynamic. However, rather than tail risks that can be ultimately modeled, exceptional bumps ahead are more in the nature of “black swans” (observations that cannot be inferred from previous data series) or “endogenous risk” (risk endogenously created by market participants).77 Hence, risk pricing becomes inherently difficult, not only because statistical history provides few clues as to what might be popping up ahead, but also because markets that are shaped by alternative bouts of euphoria and despair are unlikely to provide efficient, fundamentals‐
based pricing signals. Thus, absent an effective oversight to prevent such financial system drifts (which, as argued below, will need to rely on greatly expanded supervisory skills and powers), Basel II’s aspiration to make regulation rest on internal risk management models, bolstered by risk‐rating agencies and marke...
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