Containing Systemic Risk: Paradigm-Based Perspectives on Regulatory Reform

The surge of proposals for regulatory reforms aimed at containing systemic risk in the wake of the subprime crisis has been accompanied by an equally impressive burst of research on the drivers of financial crises. Crisis interpretations can be classified into four broad economic paradigms with very distinct and often contradictory implications for regulatory reform and the role of public policy. By clarifying the alternative conceptual underpinnings of policy, the exploration of these paradigms can help frame the debate and illuminate the underlying trade-offs.

The paradigms emerge in a world of incomplete markets from a simple taxonomy that reflects the particular friction or market failure that is considered to dominate. Thus, financial bubbles and crises can happen when (a) nobody really understands what is going on, and bad surprises lead to catastrophic mood reversals (the collective cognition paradigm); (b) some understand better than others, and they take advantage of their superior knowledge (the asymmetric information paradigm); (c) everybody understands what is going on, yet no one can do anything about it because occasional bubbles and crises occur naturally in a world with enforcement costs, agent heterogeneity, and asymmetric market access (the costly enforcement paradigm); or (d) everybody understands what is going on, yet no one does anything about it because private interests do not coincide with those of society (the collective action paradigm).¹

This paper argues that these four paradigms have markedly different prudential policy implications. At one extreme, the costly enforcement (CE) world is one of constrained optimality. Hence, while policy might possibly help smooth financial ebbs and flows by facilitating market completion, there is no role for prudential regulation and supervision. The pure asymmetric information (AI) paradigm carves out a limited role for official prudential oversight. The regulator-supervisor needs to be a dedicated representative for the uninformed and a promoter of market discipline for the informed. In contrast, the pure collective action (CA) paradigm opens up a much richer array of responsibilities for the regulator, who now needs to contain free-riding incentives, induce agents to internalize externalities, help coordinate market participants toward a socially preferable outcome, and have in place a systemic mechanism for putting out the occasional fires when they happen. The pure collective cognition (CC) paradigm further expands the supervisor's role to include informing, educating, and guiding market participants, as well as calming their frayed nerves by absorbing some of the risk faced by individuals under events that threaten the group as a whole.

These policy roles often collide head-on, and the historical piecemeal approach to prudential regulation bears the direct traces of this conflict. In the United States, for example, a lender of last resort (namely, the U.S. Federal Reserve) and deposit insurance (after the Great Depression) were introduced to address widespread collective action failures in the form of bank runs, but they exacerbated the problems of asymmetric information (especially moral hazard) that were the main culprit behind the savings and loan crisis in the late 1980s and early 1990s. The subsequent efforts of regulators to mitigate moral hazard—by tightening prudential regulation around commercial banks while letting other intermediaries be disciplined by market forces—magnified collective action failures outside commercial banking. This approach led to the rapid growth of the shadow banking system and its collapse in the subprime crisis. It severely undermined the prevailing view that markets know best and that there is little or nothing that the supervisor can add to collective action and collective cognition failures, except to promote transparency.

Looking forward, overcoming the piecemeal approach to regulation in order to find a more harmonious balance between the paradigms will be key to a successful regulatory reform. This is easier said than done, as the difficulties resulting from the inherent policy inconsistencies across paradigms are compounded by complex measurement and calibration problems. However, we discuss in this paper three crucial sets of regulatory reform issues whose resolution could accomplish a great deal toward finding such a balance. The rest of this introduction summarizes these three issues, which are then discussed...