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Uncertainty and the financial crisis

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    The majority of commentators, along with the public opinion, are inclined to identify the causes of the last financial crisis in a combination of traditional market and regulatory failures in the operation and regulation of financial markets. Whatever cannot be explained along these lines is interpreted as evidence of inability of individuals, including market professionals, to make rational choices. Without denying the importance of these factors in explaining the behavior of some of the players involved, this paper argues that the extraordinary proportions of the crisis we have experienced are better understood by looking at the specific dynamics of financial innovation through securitization of illiquid assets. Particularly, a perverse combination of Knightian uncertainty and externalities in banking seems to have been one major responsible of the financial crisis. This paper investigates the role of uncertainty and externalities in the unfolding of events that determined the financial crisis. In this perspective, financial regulation has not been just too lax or too lenient. Rather, it has distorted the choices of financial intermediaries ex-ante (inducing them to rely too much and too quickly on liquidity for funding and profits) and it has turned out to be too rigid ex-post (failing to provide the banking system with incentive-compatible forms of resilience). The implications of this approach are discussed with regard to the regulation of credit rating agencies, the pro-cyclicality of capital adequacy regulation, and the corporate governance of banks.

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    Article provided by Capco Institute in its journal Journal of Financial Transformation.

    Volume (Year): 29 (2010)
    Issue (Month): ()
    Pages: 79-93

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    Handle: RePEc:ris:jofitr:1424
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