Containing Systemic Risk: Paradigm-Based Perspectives on Regulatory Reform

Financial crises happen when: (i) nobody really understands what is going on (the collective cognition paradigm); (ii) some understand better and take advantage (the asymmetric information paradigm); (iii) everybody understands but crises are a natural part of the financial landscape (the market segmentation paradigm); or (iv) everybody understands yet fail to act because private and social interests do not coincide (the collective action paradigm). The four paradigms have different and often conflicting prudential policy implications. We propose and discuss three sets of reforms that would give due weight to the insights from the collective action and collective cognition paradigms by: (i) redrawing the regulatory perimeter to internalize systemic risk without promoting dynamic regulatory arbitrage; (ii) introducing a truly systemic liquidity regulation that moves away from a purely idiosyncratic focus on maturity mismatches; and (iii) building up the supervisory function while avoiding the pitfalls of expanded official oversight.