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

  • Viral V. Acharya

    (Asian Development Bank Institute (ADBI))

  • Thomas Cooley
  • Matthew Richardson
  • Ingo Walter

The paper analyzes the financial crisis of through the lens of market failures and regulatory failures. We present 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, we provide 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 Long-Term Capital Management, expectations of too-big-to-fail status got anchored. We propose 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://saber.eaber.org/node/23273
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Paper provided by East Asian Bureau of Economic Research in its series Macroeconomics Working Papers with number 23273.

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Date of creation: Feb 2011
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Handle: RePEc:eab:macroe:23273
Contact details of provider: Postal: JG Crawford Building #13, Asia Pacific School of Economics and Government, Australian National University, ACT 0200
Web page: http://www.eaber.org

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  12. Donald P. Morgan & Kevin J. Stiroh, 2005. "Too big to fail after all these years," Staff Reports 220, Federal Reserve Bank of New York.
  13. Gerard Caprio & Patrick Honohan, 2008. "Banking Crises," Center for Development Economics 2008-09, Department of Economics, Williams College.
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  15. Claessens,Constantijn A. & Klingebiel, Daniela & Laeven, Luc, 2004. "Resolving systemic financial crisis : policies and institutions," Policy Research Working Paper Series 3377, The World Bank.
  16. Kane, Edward J. & Klingebiel, Daniela, 2004. "Alternatives to blanket guarantees for containing a systemic crisis," Journal of Financial Stability, Elsevier, vol. 1(1), pages 31-63, September.
  17. Hovakimian, Armen & Kane, Edward J. & Laeven, Luc, 2002. "How Country and Safety-Net Characteristics Affect Bank Risk-Shifting," CEI Working Paper Series 2002-10, Center for Economic Institutions, Institute of Economic Research, Hitotsubashi University.
  18. Cordell, Lawrence R & MacDonald, Gregor D & Wohar, Mark E, 1993. "Corporate Ownership and the Thrift Crisis," Journal of Law and Economics, University of Chicago Press, vol. 36(2), pages 719-56, October.
  19. John, Kose & John, Teresa A. & Senbet, Lemma W., 1991. "Risk-shifting incentives of depository institutions: A new perspective on federal deposit insurance reform," Journal of Banking & Finance, Elsevier, vol. 15(4-5), pages 895-915, September.
  20. Timothy J. Kehoe & Edward C. Prescott (), 2007. "Great depressions of the twentieth century," Monograph, Federal Reserve Bank of Minneapolis, number 2007gdott.
  21. 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.
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