28 ante expectation of bailouts) but wisdom should eventually arise from the pain.<sup>65</sup> Correspondingly, it would be better if the lender-of-last-resort (LOLR) function did not exist. Bank runs are healthy manifestations of market discipline. Stopping runs unnecessarily protects banks that should fail and aggravates the misalignment of incentives for all other banks. Similarly, deposit insurance can only be justified by consumer protection but, given its adverse moral hazard implications, a pure agency supervisor would probably conclude that, on balance, the world would be a better place without it.<sup>66</sup> By contrast, in the externalities paradigm, the nature of the problem makes learning irrelevant. As long as externalities are not internalized, participants only see their side of the story, no matter what. Moreover, there is no possible learning from exogenous and random acts of god or from self-fulfilling runs in a multiple equilibrium world. Thus, to the extent that it is too expensive for society to prevent runs through large ex-ante buffer requirements, an efficient LOLR becomes a socially superior solution and the cornerstone of the regulatory edifice. Also, as his forebears after the Great Depression, an externalities supervisor would conclude that deposit insurance is needed to induce the small uninformed depositors to join the banking system while preventing them from crying wolf and causing systemic havoc without justification. Again, however, having fire safety only a 911 call away hardly promotes incentives for keeping a fire extinguisher at home, another good example of regulatory collision between the paradigms.

**Table 3.  The Need for A Safety Net**

|||**Paradigm **<br>||
|---|---|---|---|
|**_Issue_**|**Agency**|**Externalities**|**Mood Swings**|
|_Can players learn_<br>_on their own?_|Probably Yes|No|Apparently not|
|_Is an ex-post LOLR_<br>_needed?_|No, it is<br>Counterproductive|Yes, to provide<br>systemic liquidity|Yes, to absorb<br>systemic risk|
|_Is a deposit_<br>_insurance needed?_|Probably not|Yes, to limit risks<br>of “wrong” runs|Yes, to limit<br>impact of mood<br>swings|

Interestingly, as regards the scope for learning, the mood swings paradigm lies somewhere in the middle. The constantly evolving environment makes some learning possible but tricky. One would think that agents should learn to be more cautious and eventually come to realize that, even if the scope for the truly new is constrained by path dependence, nasty surprises can emerge and that “not all that glitters is gold”. History has

> 65 The remaining question, of course, is whether such a system would be “fair” to the smaller and less educated consumers who might be scared away and remain forever on the fringes but in the end this is likely to be an issue of consumer protection more than systemic stability.

> 66 Indeed, from a pure moral hazard perspective, the expansion of the safety net (particularly the creation of deposit insurance) can be seen as a mistaken knee-jerk reaction that has come back to haunt the current regulatory architecture and the goal should be to get rid of it. See for example Herring and Santomero (2000), Gale (2004), and Calomiris (2008).