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Market Failures and Regulatory Failures: Lessons from Past and Present Financial Crises

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Author Info

  • Acharya, Viral V.

    (Asian Development Bank Institute)

  • Cooley, Thomas

    (Asian Development Bank Institute)

  • Richardson, Matthew

    (Asian Development Bank Institute)

  • Walter, Ingo

    (Asian Development Bank Institute)

Abstract

The paper analyzes the financial crisis of 2007–2009 through the lens of market failures and regulatory failures and presents a case that there were four primary failures contributing to the crisis: excessive risk-taking in the financial sector due to mispriced government guarantees; regulatory focus on individual institution risk rather than systemic risk; opacity of positions in financial derivatives that produced externalities from individual firm failures; and runs on the unregulated banking sector that eventually threatened to bring down the entire financial sector. In emphasizing the role of regulatory failures, the paper provides a description of regulatory evolution in response to the panic of 1907 and the Great Depression, why the regulation put in place then was successful in addressing market failures, but how, over time, especially around the resolutions of Continental Illinois, Savings and Loans crisis and the Long-Term Capital Management, expectations of too-big-to-fail status got anchored. The paper proposes specific reforms to address the four market and regulatory failures we identify, and we conclude with some lessons for emerging markets.

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File URL: http://www.adbi.org/files/2011.02.08.wp264.market.regulatory.failures.lessons.gfc.pdf
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Bibliographic Info

Paper provided by Asian Development Bank Institute in its series ADBI Working Papers with number 264.

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Length: 41 pages
Date of creation: 08 Feb 2011
Date of revision:
Handle: RePEc:ris:adbiwp:0264

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Keywords: global financial crisis; LTCM; market failures; regulation; emerging markets;

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  1. Lasse Heje Pederson & Markus K Brunnermeier, 2007. "Market Liquidity and Funding Liquidity," FMG Discussion Papers dp580, Financial Markets Group.
  2. Gerard Caprio & Patrick Honohan, 2008. "Banking Crises," Department of Economics Working Papers 2008-07, Department of Economics, Williams College.
  3. Penas, Maria Fabiana & Unal, Haluk, 2004. "Gains in bank mergers: Evidence from the bond markets," Journal of Financial Economics, Elsevier, vol. 74(1), pages 149-179, October.
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  8. Joshua D. Coval & Jakub W. Jurek & Erik Stafford, 2009. "Economic Catastrophe Bonds," American Economic Review, American Economic Association, vol. 99(3), pages 628-66, June.
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  11. Viral V. Acharya & João A. C. Santos & Tanju Yorulmazer, 2010. "Systemic risk and deposit insurance premiums," Economic Policy Review, Federal Reserve Bank of New York, issue Aug, pages 89-99.
  12. Huberto M. Ennis & H.S. Malek, 2005. "Bank risk of failure and the too-big-to-fail policy," Economic Quarterly, Federal Reserve Bank of Richmond, issue Spr, pages 21-44.
  13. Lucas, Deborah & McDonald, Robert L., 2006. "An options-based approach to evaluating the risk of Fannie Mae and Freddie Mac," Journal of Monetary Economics, Elsevier, vol. 53(1), pages 155-176, January.
  14. Donald P. Morgan & Kevin J. Stiroh, 2005. "Too big to fail after all these years," Staff Reports 220, Federal Reserve Bank of New York.
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