NOTE NUMBER 10 53043 PUBLIC POLICY FOR THE PRIVATE SECTOR NOVEMBER 2009 Financial Paradigms FINANCIAL AND PRIVATE SECTOR DEVELOPMENT VICE PRESIDENCY Augusto de la Torre and What Do They Suggest about Regulatory Reform? Alain Ize What marke t an d r e g ula t o r y is s ue s le d t o t he s ub p r im e c r isi s ? H o w Augusto de la Torre (adelatorre@worldbank should p rud e ntia l r e g ula t io n b e f ix e d ? T he a ns we r s d e p e nd o n t h e .org) is chief economist, interp re tative le ns e s -- o r " p a r a d ig m s " -- t hr o ug h whic h o ne se e s and Alain Ize (aize@ f inance. The agenc y p a r a d ig m , whic h ha s d o m ina t e d r e c e nt re g u l a t o r y worldbank.org) a consul- tant, in the Latin America p olicy, se e ms to b e inf lue nc ing m uc h o f t he e m e r g ing r e f o r m a g e n d a . and the Caribbean Region But collective w e lf a r e f a ilur e s -- p a r t ic ula r ly e x t e r na lit ie s -- a n d of the World Bank. colle ctive cognit io n f a ilur e s -- p a r t ic ula r ly m o o d s wing s -- we re a t l e a s t This is the 10th in a as imp ortant in d r iv ing t he c r is is . All t hr e e p a r a d ig m s s ho u l d series of policy briefs on the crisis--assessing the the ref ore b e inte g r a t e d int o a m o r e b a la nc e d p o lic y a g e nd a. B u t policy responses, shedding d oing so will b e d if f ic ult b e c a us e t he y o f t e n ha v e inc o ns is t en t p o l i c y light on financial reforms imp lications. currently under debate, and providing insights for emerging-market policy Like the other two large financial crises in mod- Three paradigms makers. ern U.S. history--the Great Depression and the Why do the managers of financial institutions savings and loan crisis--the subprime crisis was continue making such commitments while triggered by the inability of financial intermediar- repeatedly failing at honoring them? There are ies to withstand substantial macroeconomic price two possible explanations: either they understand volatility. The culprit varied from crisis to crisis the risks and go ahead because it suits them, or THE WORLD BANK GROUP (stock prices in the Great Depression, deposit they go ahead because they do not understand rates in the savings and loan crisis, housing the risks. prices in the subprime crisis). But all three crises The first option leads to two distinct para- resulted from a wedge between the underlying digms, the agency paradigm and the collective wel- value of financial intermediaries' assets and that fare paradigm. In the agency paradigm, managers of their liabilities, which prevented institutions intentionally take advantage of the less informed from honoring the implicit insurance commit- or farther removed. In particular, they expect to ments to their clients. High leverage and liquidity capture the upside while leaving the downside to on demand, which limited the size of the buf- others (moral hazard). In the collective welfare fers available against shocks, made the wedges paradigm, managers have no ill intent but focus lethal. only on their private costs and benefits, which FINANCIAL PARADIGMS WHAT DO THEY SUGGEST ABOUT REGULATORY REFORM? do not coincide with society's costs and benefits. reflects fund suppliers' "opportunistic" desire to This wedge can lead to socially suboptimal out- stay "ahead of the crowd" by maintaining access to comes and reflects uninternalized externalities their funds and keeping a quick exit option open (the failure of individuals to take into account at all times. In the face of bargaining costs that the consequences of their actions for society), hinder a socially preferable collective response, free riding (the use by individuals, at no cost, of this is an optimal way for each supplier of funds something that the system offers), and coordina- to address both idiosyncratic risks (a quick exit tion failures (the failure of individuals to act in disciplines fund users) and aggregate risks (liquid the group's and their own best interest because portfolios and flights to cash mitigate exposure 2 doing the right thing would be optimal only if to tail risk1 and genuine uncertainty). everybody else in the group did it too). Financial markets and intermediaries help The second option leads to the collective cogni- investors bridge these gaps along a continuum. tion paradigm. This paradigm arises from difficul- At one extreme are commercial banks, the pro- ties in understanding the dynamics and internal totypical financial intermediaries. Banks help workings of the system as a whole. A constantly depositors bridge the information and control evolving, uncertain world of rapid financial inno- gap through soft private information (relation- vation leads to mood swings driven by rational ship lending), debt contracts (a disciplining but poorly informed decision making, bounded device), and capital ("skin in the game"). They rationality, or emotional decision making. This bridge the uncertainty and liquidity gaps by offer- paradigm is naturally associated with bouts of ing investors deposits (debt contracts) redeem- euphoric enthusiasm followed by episodes of sud- able at par and on demand and by absorbing den alarm, panic, and deep retrenchment. the ensuing risks through capital and liquidity These paradigms mirror the three basic gaps buffers. But by interposing their balance sheet that finance seeks to bridge (figure 1). The infor- between borrowers (through assets that are illiq- mation and control gap, associated with the agency uid and whose underlying value is uncertain and paradigm, reflects fund suppliers' exposure to the fluctuates with economic conditions) and inves- idiosyncratic risks and information costs involved tors (through liabilities that are liquid and whose in properly screening and monitoring fund users value is fixed by contract), intermediaries can and enforcing contracts with them. The uncertainty become exposed and add to systemic risk, making and volatility gap, associated with the collective financial intermediation inherently fragile. cognition paradigm, reflects fund suppliers' aver- Banks face all types of agency problems, the sion to becoming exposed to aggregate risks over most important being moral hazard. If all deposi- which they have no control and that they may not tors were well informed, banks could eliminate understand. The liquidity and collective action gap, moral hazard by holding enough capital. But the associated with the collective welfare paradigm, mix of small, uninformed depositors and larger, Figure The gaps finance seeks to bridge and the pitfalls it encounters 1 Risk Gap Asymmetric information and control Response Pick, monitor, and diversify borrowers Market failures Adverse selection Moral hazard and shirking False reporting Paradigm Agency Idiosyncratic Liquidity and Stay liquid Externalities Collective collective and grab Free riding welfare action opportunities Coordination failures Aggregate Systemic Share risk and Collective uncertainty and match exposure Mood swings cognition volatility to risk appetite better-informed investors can lead to inefficient actors involved in the "originate to distribute" model outcomes in which banks and wholesale inves- increased the scope for agency frictions between tors benefit at the expense of retail depositors or the different parties (Ashcraft and Schuermann their insurance coverage (Huang and Ratnovski 2008). Agency problems were also exacerbated 2008). Governance issues between bank manag- within institutions as incentive misalignments ers, shareholders, and investors compound the (including those stemming from compensation problem by superimposing additional layers of schemes and mark-to-market practices) widened moral hazard. between managers who were focused on short-run Banks are also exposed to externalities and returns and shareholders who largely preferred to 3 free-rider incentives, most notably those asso- vote with their feet rather than exercise governance ciated with liquidity, which has the features of through the board of directors. a public good (Holmstrom and Tirole 1998). In the collective welfare paradigm everyone Thus, during the buildup to a crisis, their fail- counted on everyone else for support but no ure to internalize the systemic implications of one adequately internalized the systemic risks short-term borrowing increases overall fragil- of such cross-support. In the process a great fal- ity. In turn, the flight to liquidity as the market lacy of composition developed, leading market collapses exacerbates the violence of the down- players (and supervisors) to believe that risk turn. Collective welfare frictions can also induce protections at the individual level would add up bubble-type deviations of asset prices from their to systemic risk protection. Instead, by unload- fundamentals or result in underproduction of ing (selling) risk--for example, through credit information and monitoring as well as overexten- default swaps--to other financial institutions, sion of credit during upswings and overcontrac- intermediaries further intensified negative sys- tion during downswings. temic externalities. Like investors, banks are also vulnerable to In the collective cognition paradigm the making irrational or poorly informed decisions in shift from traditional to shadow banking can be the face of uncertainty. During financial expan- interpreted as the natural evolution of a rapidly sions the decline in macro-financial volatility, deepening financial system in which markets predictable pricing, and deep market liquidity and intermediaries increasingly complemented feeds risk appetites and exuberance ("this time each other. But the creation of new instruments around things are different and the good times and forms of intermediation outpaced the ability are here to stay"). But a significant dissonance can of market participants and supervisors to fully initiate a brutal downward mood swing driven by comprehend their implications and handle the risk aversion and fear of the unknown.2 associated risks and uncertainty. Compounding this problem was a failure to fully understand the The subprime crisis: new bottle, dynamic links between financial sector and asset same wine? prices and the feedback loop between rising asset During the buildup to the subprime crisis, highly prices and expanding credit. leveraged intermediation developed outside the confines of traditional banking, in what has now Why did regulation fail? become known as "shadow banking." By radically In this multi-paradigm world the failure of regula- expanding the interface between markets and tion in the subprime crisis can be explained by a intermediaries, the explosive growth of shadow piecemeal approach that looked at one paradigm banking brought new problems and issues. But at a time and, in trying to address the central the same underlying pitfalls of agency problems, problem in one paradigm, made problems in the liquidity runs, and mood-driven cycles were at others worse; and by a regulatory framework that work, reappearing with a vengeance. was designed to help intermediaries overcome Each paradigm can provide a very different inter- the first two gaps of finance but not the third. pretation of the crisis that is nonetheless largely The current regulatory regime rests on three consistent with the observed facts. In the agency key pillars: prudential norms that seek to align paradigm the multiplication of intermediaries and principal and agent incentives ex ante; an ex FINANCIAL PARADIGMS WHAT DO THEY SUGGEST ABOUT REGULATORY REFORM? post safety net (deposit insurance and lender more closely linked to externalities and coordina- of last resort) aimed at enticing small deposi- tion failures than to agency problems. But the tors to join the banking system and forestalling creation of the Federal Reserve System in 1913 contagious runs on otherwise solvent institutions; and the introduction of deposit insurance after and a "line in the sand" separating the world of the Great Depression exacerbated the agency­ the prudentially regulated (mainly commercial moral hazard problem. In turn, the strengthen- banking) from that of the unregulated. ing of prudential norms after the savings and In turn, the line-in-the-sand pillar rests on loan crisis, meant to address the acute manifesta- at least three key arguments. First, regulation is tions of moral hazard observed during that crisis, 4 costly and can produce unintended distortions. exacerbated collective welfare failures. The side- It can limit intermediation, financial innovation, by-side existence of a regulated sector--where and competition, and it needs to be accompanied systemic concerns were partially factored in-- by good--and thus inherently costly--supervi- and an unregulated sector--where externalities sion. Second, oversight on the cheap can exac- were not at all internalized--created a wedge in erbate moral hazard by giving poorly regulated returns between the two worlds. Investors left the intermediaries an undeserved "quality" label and regulated world in droves to join the world of the an easy scapegoat (blame the regulator if there is less regulated, highly leveraged and short-funded a problem). Third, investors outside the realm of intermediaries, rapidly increasing their relative the small depositor should adequately monitor size and boosting systemic risk in the process. the unregulated financial intermediaries, making Moreover, while focusing on collective welfare sure their capital is sufficient to eliminate moral failures and moral hazard, regulation failed all hazard and other agency frictions. along to address the issues arising from uncer- Consistent with this line-in-the-sand rationale, tainty and mood swings. Thus the regulatory only deposit-taking intermediaries are pruden- architecture that is in place today became seri- tially fully regulated and supervised under the ously unbalanced. current regulatory architecture. In exchange, and reflecting their systemic importance, they What is the role of supervisors? benefit from a safety net. Other financial inter- Regulatory reform is complicated by the fact that mediaries (and all other capital market players) the internal logic of each paradigm leads to differ- neither enjoy the safety net nor are burdened ent and often mutually inconsistent implications. by full-blown prudential norms. Instead, they Consider first the relative roles of markets and are subject mostly (if not only) to market disci- supervisors (table 1).3 pline, enhanced by securities market regulations In the agency and collective welfare paradigms focused on transparency, governance, investor the aims differ (reducing principal-agent fric- protection, market integrity, and the like. tions in the first, and internalizing social costs The early history of regulatory intervention, and facilitating coordination in the second), but which was marked by the introduction of the the need to align incentives is clear in both. In safety net in response to repeated bank runs, was the collective cognition paradigm, by contrast, Table What is the role of supervisors? 1 Issue Agency paradigm Collective welfare paradigm Collective cognition paradigm What is the market failure? Betting with someone else's money Engaging in opportunistic behavior Acting on weak information or biased that conflicts with the social good perceptions What are the objectives of Align incentives through skin in the game Align incentives by internalizing Temper moods and tame creativity prudential regulation? externalities Can risk be priced? Yes Probably not fully (hundred-year floods) Probably not (unless supervisor is Moses-like) What is the role of supervisors? Enhancer of market discipline, crime police Crowd manager, firefighter Scout, moderator, firefighter the aim is to temper moods and keep innovation and steering the financial boat away from ice- under control. While there are no obvious incon- bergs are not easy tasks. Systemic risk analysis is sistencies, the two sets of objectives call for differ- therefore unlikely to arise spontaneously as a ent styles of supervision. Similarly, the scope for profitable market activity and should probably risk pricing, which depends in part on whether be viewed instead mostly as a public good, to be systemic price bubbles and crises can be avoided, supplied by supervisors. varies correspondingly across the paradigms, also leading to different roles for supervisors. What about regulatory reform? In the agency paradigm anyone with enough Much progress has been made in designing 5 "skin" invested in the game has incentives to keep the agenda for regulatory reform, with detailed risk taking within socially acceptable bounds. (though not always specific) proposals having Once principal-agent problems are under control, already emerged.5 As could be expected, these systemic crises should not occur and prices pro- proposals have a strong agency emphasis, includ- vide a sound basis for day-to-day micro-prudential ing measures to enhance transparency and con- risk management. Accordingly, the main role of sumer protection, limit conflicts of interest, the supervisor is to put into place the necessary improve governance, alter management compen- apparatus for markets to perform well. Once this sation schemes, and increase skin-in-the-game is done, the supervisor's only remaining role is requirements. All these are clearly essential.6 checking compliance and policing crime. Consistent with the emphasis in this brief on By contrast, in the collective welfare paradigm, the need for a better balance across paradigms, where the key dimension of risk is systemic, the however, the focus here is on the reform propos- scope for market assistance is much more limited. als for the other two paradigms. Markets can provide insurance only if they are able to calibrate the risks and costs of systemic Dealing with externalities breakdowns and to withstand their strains, both of Let's start with the collective welfare paradigm. which seem questionable.4 The role of the super- There is widespread agreement on the need to visor grows in inverse proportion. The supervisor tackle systemic risk. In particular, there seems to should induce intermediaries to internalize exter- be an emerging consensus that some measure of nalities and enhance the stability of the system "systemic importance" should be the criterion through prudential buffers. But because putting used when deciding which financial institutions into place fully crisis-proof buffers is likely to be to bring into the sphere of prudential regulation. socially too expensive, risks of occasional systemic This proposal is problematic, however, because it crises ("hundred-year floods") will persist. is based on a purely static definition of systemic In the collective cognition paradigm the importance that is likely to exacerbate regulatory scope for market assistance is even more lim- arbitrage over time, with financial transactions ited, because uncertainty now dominates risk. moving in waves outside the regulated sphere, as Risk pricing becomes inherently difficult, not in the buildup to the subprime crisis. Moreover, only because statistical history provides few clues applying this proposal could well be an opera- on what might be popping up ahead but also tional nightmare. If the systemic distinction is because markets shaped by alternating bouts of based on size, unregulated intermediaries just euphoria and despair are unlikely to provide effi- below that size could multiply in number and cient pricing signals. It does not follow, however, engage in "systemic herding." And distinctions that in this paradigm "anything goes." Instead, based on interconnectedness are likely to be price bubbles and financial market dynamics extremely complex and subject to many compet- have an internal logic that makes them broadly ing interpretations of what is truly systemic. In the predictable. Moreover, well-trained observers end they might have unpredictable effects over should be able to grasp how the system is wired, time and may provide a false sense of security. connect the dots, and recognize the possible In addition, moving institutions on and off the cracks ahead. Still, separating bubbles from fun- systemically important list would have adverse damentals, identifying potential vulnerabilities, signaling implications. FINANCIAL PARADIGMS WHAT DO THEY SUGGEST ABOUT REGULATORY REFORM? Simplicity would better serve the goal of avoid- The need for regulations to address the sys- ing regulatory arbitrage. Thus one proposal temic vulnerabilities resulting from short-term would be to have a single set of prudential regu- wholesale funding has also become widely rec- lations for all intermediaries that take deposits or ognized. But the proposals based on controlling borrow in the market, yet allow for the existence the mismatch between the maturity of assets and of unregulated (but licensed) intermediaries that that of liabilities appear problematic. Matching may borrow only from the regulated. Because short liabilities with short assets can protect the the unregulated intermediaries could fund them- liquidity of an individual intermediary but at the selves only from the regulated, a dollar lent to expense of exacerbating systemic vulnerability. In 6 a final borrower through an unregulated inter- systemic events short loans become as illiquid as mediary would end up paying the same Pigovian long loans unless intermediaries press borrowers tax (that is, the tax that would internalize all the to repay the loans. But if they do so, they shift externalities inflicted on the system by each indi- the liquidity pressure onto somebody else, the vidual institution, including those associated with final borrower or another intermediary, thereby systemic liquidity, as discussed below) as a dol- increasing default risk across the system and con- lar lent through a regulated intermediary. Thus tributing to downward asset spirals. systemic risk would be evenly internalized across A better solution would be to turn the con- all possible paths of financial intermediation. At ventional maturity mismatch principle--it is the same time, because the unregulated interme- okay to borrow short if you also lend short--on diaries would not need to meet entry require- its head. A systemic liquidity tax would penal- ments, this scheme would favor innovation and ize the short funding from uninsured wholesale competition. It would also limit the cost of over- investors as well as the short lending by regu- sight, because the activities of the unregulated lated intermediaries, at least to the unregulated would be monitored through their contractual financial intermediaries. The tax would be aimed relationships with the regulated intermediaries at pricing appropriately the value of the option that lend to them. to "lend short and run" that deposit insurance Admittedly, this proposal does not directly and the lender of last resort implicitly provide. address the too-big-to-fail, too-interconnected-to- It could take the form of a capital surcharge; a fail (TBTF-TITF) problem. But this is not as severe risk-adjusted premium on deposit insurance; or a shortcoming as it may seem, for several reasons. a risk-adjusted premium on newly created sys- First, it is simply wrong to equate systemic risk with temic liquidity insurance linked to the lender-of- TBTF-TITF. Systemic risk can be present even last-resort facility. Calibrating this tax will not be without TBTF-TITF. Second, systemic risk is not trivial, however, not least because of the inherent addressed by fueling regulatory arbitrage (which conflict across paradigms (lending short disci- applying stricter prudential regulations to TBTF- plines borrowers under the agency paradigm). TITF institutions would most probably do) but by removing (or at least lessening) the root causes Dealing with mood swings leading to systemic events. A uniformly applied Now let's turn to the collective cognition para- systemic liquidity tax, as discussed below, would be digm, where the virtual absence of regulatory an important step toward this goal. Third, stricter reform proposals is remarkable. While some regulation would be of little or no help if a TBTF- reports do recognize that markets can be caught TITF institution becomes troubled or unviable. in mood swings, there are few specific recom- That scenario, the main concern of proponents of mendations yet on how to address the associated tougher regulations for such institutions, calls for market inefficiencies. This is an important gap different instruments, chiefly a suitable framework that needs to be filled. In particular, the supervi- for resolution of failed institutions--with powers sor's role will need to be broadened beyond that to undertake such actions as closing, intervening contemplated in the proposals currently aimed at in, and restructuring institutions; unwinding posi- enhancing systemic supervision, which are based tions; and separating the "good" and "bad" parts solely on collective welfare frictions (intercon- of the balance sheet. nectedness, contagious runs, and the like). In the rational expectations version of the the obvious instrument to consider in this con- collective cognition paradigm--where mood nection. Mood swings thus militate in favor of swings reflect a rational updating of imperfect an appropriate mix of rules and discretion in information--the only new function of the dealing with systemic fluctuations in credit and supervisor is that of scouting. Once warned by asset prices. Such an approach would combine the supervisor of the potential icebergs ahead, preset, cyclically adjusted prudential norms rational markets should change course on their that target expected risks (dynamic provisioning own. As noted, however, scouting is a difficult requirements to offset predictable swings in function that will require additional public default risk over the cycle) with countercyclical, 7 resources. Because it turns on its head the discretionally adjusted prudential norms that tar- agency paradigm mantra that intermediaries get unexpected risks (capital adjustments reflecting know best, it will constitute a major change in increases in systemic uncertainty that make tail supervisory philosophy and organization. risks grow). The cyclically adjusted prudential Scouting also raises a number of delicate ques- norms should remain under the direct respon- tions, including what is the most useful way to look sibility of the supervisory agency. The counter- ahead and assess possible systemic vulnerabilities. cyclical, discretionally adjusted prudential norms While many efforts are under way to redesign should naturally become part of the toolkit of stress testing within a more systemic context that the central bank. Clearly, however, appropriate takes into account tail risk and changes in correla- arrangements will be needed to ensure proper tions, the question arises whether the task of find- coordination between the supervisory agency and ing the cracks in the system is more qualitative the central bank. than quantitative. Another key question is what will be a proper balance between on-site and off- Conclusion site work. Many experienced supervisors seem to To be successful, regulatory reform will need lean in favor of bringing tomorrow's supervision to integrate the key insights of all three para- closer to the ground, through a heavier on-site digms underpinning the world of finance. But presence. Such an approach makes perfect sense regulatory reform is complicated by the inherent in the agency paradigm. But in the collective cog- policy inconsistencies across paradigms, which nition paradigm the emphasis might be more on become readily apparent once their internal understanding the systemic vulnerabilities than logic is worked out. Agency issues can be largely on verifying the individual risk assessments. From solved through the self-correcting forces of well- this perspective it is no longer so clear whether functioning financial markets, making life easier the best response is more on-site presence or for regulators and financial economists alike. By better off-site supervision. contrast, markets cannot on their own address In the alternative interpretation of the collective the daunting challenges posed by collective wel- cognition paradigm--a world of bounded rational- fare and collective cognition failures. Instead, the ity and sentiment-driven traders--information and thorny issues linked with these paradigms (tail analysis will not suffice. Instead, market guidance risks, free riding, bounded rationality, genuine will require adding deeds to words. In turn, this uncertainty) put a heavy burden on regulators will require boosting the supervisor's capacity (and and sit uncomfortably in the world of mainstream skills) to exert judgment-based discretionary inter- finance. ventions aimed at restricting specific instruments Moreover, attempts to address the problems and forms of intermediation that may become identified under one paradigm can often worsen riskier as they develop. To this end, supervisors the problems identified under the others. Things will need more powers to regulate and standardize are made no easier by the problem of attribution; financial innovation. the behavior of financial markets conflates agency, Supervisors will also need more powers to slow collective welfare, and collective cognition fric- down credit cycles and expand prudential buffers tions in such a complex way that their individual when systemic uncertainty increases. Judgment- effects are virtually impossible to sort out empiri- based countercyclical prudential norms seem cally. Thus the path ahead will ultimately require FINANCIAL PARADIGMS WHAT DO THEY SUGGEST ABOUT REGULATORY REFORM? a judgment call as to whether the benefits of a 5. See Brunnermeier and others (2009), FSA (2009), regulation on account of one paradigm exceed Acharya and Richardson (2009), and the April 2009 the potential costs on account of another. Declaration of the G-20 Summit, to cite just a few. With these constraints in mind, this brief 6. What makes many of these issues hard nuts to crack has argued in favor of three main proposals to is their frequent location at the interface between address issues of externalities and mood swings. two or more paradigms. For example, finding ways to crisisresponse First, to limit regulatory arbitrage, prudential induce shareholders or investors to do a better job at regulation should be applied uniformly to all monitoring and controlling managers (an agency prob- The views published here intermediaries that take deposits or borrow in lem) requires overcoming both free-rider problems and are those of the authors and the market. However, unregulated intermedi- mood swings. should not be attributed aries should be allowed as long as they borrow to the World Bank Group. only from regulated ones. This proposal stands in References Nor do any of the conclusions contrast with the apparently emerging consensus Acharya, Viral, and Matthew Richardson, eds. 2009. Re- represent official policy of that intermediaries should be subject to differ- storing Financial Stability: How to Repair a Failed System. the World Bank Group or ent regulatory rigor depending on their systemic Hoboken, NJ: John Wiley & Sons. of its Executive Directors or importance. Ashcraft, Adam, and Til Schuermann. 2008. "The Seven the countries they represent. Second, a systemic liquidity tax should be Deadly Frictions of Subprime Mortgage Credit Secu- designed that penalizes both short-maturity bor- ritization." Federal Reserve Bank of New York. To order additional copies rowing and short-maturity lending. This stands in Brunnermeier, Markus, Andrew Crockett, Charles contact Suzanne Smith, contrast with the more popular view that would Goodhart, Avinash Persaud, and Hyun Shin. 2009. managing editor, penalize maturity mismatches. The Fundamental Principles of Financial Regulation. The World Bank, Third, in recognition of the importance of Geneva Report on the World Economy 11. Geneva: 1818 H Street, NW, uncertainty and the need to temper moods, International Center for Monetary and Banking Washington, DC 20433. the central bank should be empowered with a Studies; London: Centre for Economic Policy countercyclical prudential norm that could be Research. Telephone: calibrated discretionally in light of unexpected de la Torre, Augusto, and Alain Ize. 2009. "Regulatory 001 202 458 7281 changes in circumstances. This stands in contrast Reform: Integrating Paradigms." Policy Research Fax: with the popular view that countercyclical pru- Working Paper 4842, World Bank, Washington, DC. 001 202 522 3480 Email: dential norms should be only rules based. FSA (U.K. Financial Services Authority). 2009. The ssmith7@worldbank.org Turner Review: A Regulatory Response to the Global Bank- ing Crisis. London. Produced by Grammarians, Inc. Holmstrom, Bengt, and Jean Tirole. 1998. Private and Notes Public Supply of Liquidity. NBER Working Paper 5817. Printed on recycled paper This brief is based on a longer paper in the World Bank Cambridge, MA: National Bureau of Economic Policy Research Working Paper series (de la Torre and Research. Ize 2009). Huang, Rocco, and Lev Ratnovski. 2008. "The Dark 1. The risk of low-probability, extreme events at the Side of Bank Wholesale Funding." Paper presented upper end of the risk distribution. at the World Bank and International Monetary Fund 2. The argument that mood swings play an important Conference on Risk Analysis and Management, role in financial bubbles and panics finds its roots in Washington, DC, October 2­3. Keynes's "animal spirits" and Hyman Minsky's writings Kindleberger, Charles, and Robert Aliber. 1996. Manias, on financial crises and was popularized by Kindleberger Panics, and Crashes: A History of Financial Crises. and Aliber (1996) and Shiller (2006). Hoboken, NJ: John Wiley & Sons. 3. Similar inconsistencies arise for the justification for a Shiller, Robert. 2006. Irrational Exuberance. Princeton, safety net and the manner of prudential oversight. See NJ: Princeton University Press. de la Torre and Ize (2009). 4. The jury is still out on whether partial insurance schemes might help provide useful market signals. This Note is available online: http://rru.worldbank.org/PublicPolicyJournal