Regulatory Reform : Integrating Paradigms
The Subprime crisis largely resulted from failures to internalize systemic risk evenly across financial intermediaries and recognize the implications of Knightian uncertainty and mood swings. A successful reform of prudential regulation will need to integrate more harmoniously the three paradigms of moral hazard, externalities, and uncertainty. This is a tall order because each paradigm leads to different and often inconsistent regulatory implications. Moreover, efforts to address the central problem under one paradigm can make the problems under the others worse. To avoid regulatory arbitrage and ensure that externalities are uniformly internalized, all prudentially regulated intermediaries should be subjected to the same capital adequacy requirements, and unregulated intermediaries should be financed only by regulated intermediaries. Reflecting the importance of uncertainty, the new regulatory architecture will also need to rely less on markets and more on "holistic" supervision, and incorporate countercyclical norms that can be adjusted in light of changing circumstances.
| Summary: | The Subprime crisis largely resulted
from failures to internalize systemic risk evenly across
financial intermediaries and recognize the implications of
Knightian uncertainty and mood swings. A successful reform
of prudential regulation will need to integrate more
harmoniously the three paradigms of moral hazard,
externalities, and uncertainty. This is a tall order because
each paradigm leads to different and often inconsistent
regulatory implications. Moreover, efforts to address the
central problem under one paradigm can make the problems
under the others worse. To avoid regulatory arbitrage and
ensure that externalities are uniformly internalized, all
prudentially regulated intermediaries should be subjected to
the same capital adequacy requirements, and unregulated
intermediaries should be financed only by regulated
intermediaries. Reflecting the importance of uncertainty,
the new regulatory architecture will also need to rely less
on markets and more on "holistic" supervision, and
incorporate countercyclical norms that can be adjusted in
light of changing circumstances. |
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