# **1. Introduction**

While macroeconomic modeling with financial frictions—a research agenda most suitable to macroprudential policy development—has made impressive progress over the last fifteen years (to the point where, arguably, finance is no longer a “veil”), the gap between theory and policy remains large.<sup>1</sup> To help bridge this gap, we explore the conceptual foundations of macroprudential policy in light of the theoretical literature on financial frictions and from the perspective of four distinct paradigms (analytical lenses) that constitute a convenient, conceptually revealing organizing tool. The paradigms derive from a typology that interacts the two basic types of market failures that have traditionally motivated the need for financial regulation (principal-agent and collective action failures) with two cognition modes (unconstrained and constrained), all in an aggregate risk setting. In the first mode, agents do not face significant cognitive challenges because they are fully rational _and_ the risk environment evolves slowly enough to limit learning frictions. In the second, agents are boundedly rational _or_ are constrained by the learning frictions that arise in a rapidly evolving, uncertain risk environment. This approach gives rise to four distinct and largely orthogonal justifications for macroprudential policy. To better anchor this construct, we first review two alternative rationalizations of the pre-Lehman microprudential regulatory architecture that focus on idiosyncratic risk and treat aggregate risk as exogenous and invariant.

This paper is structured as follows. Section 2 reviews two possible rationalizations of preLehman regulation, based on, respectively, bounded rationality and public moral hazard. Section 3 explores each of the four rationales for post-Lehman macroprudential oversight. Section 4 concludes by discussing the cross-paradigm policy tensions and trade-offs.

# **2. The pre-Lehman microprudential world**

The pre-Lehman prudential regulatory architecture rested on two pillars, the first ( _the exante pillar_ ) aimed at encouraging sound financial intermediation and preventing bank failures through prudential regulation, the second ( _the ex-post pillar_ ) at limiting the social costs of a financial crisis through a financial safety net (Figure 1). These two pillars were only weakly connected because the different rationales that underpinned them were never adequately reconciled. Such an uneasy construct largely reflects the course of pre-Lehman historic events, particularly in the U.S. The safety net (deposit insurance and lender of last resort) was introduced early on as a response to collective action problems as reflected in the bank runs of the 19<sup>th</sup> century and the Great Depression. The Basel I and II prudential constructs came about largely as a response to the principal-agent (reckless risk taking and fraud) problems of the S&Ls crisis. Such a conceptual fragility, born from haphazard responses to financial crises of very different natures, became all too obvious during the recent global crisis.

> 1 See Brunnermeier, Eisenbach and Sannikov (2012) for a comprehensive survey on the macroeconomic impact of financial frictions. Bank of England (2009) and Galati and Moessner (2012) provide broad policy overviews. Hanson, Kashyap and Stein (2011) or De Nicolo, Favara and Ratnovski (2012) connect theory and policy. Kashyap, Tsomocos and Vardoulakis (2014a) propose a framework for macroprudential regulation based on the various functions that the financial system plays, rather than on a typology of risk settings as we do here. We believe the two approaches to be largely complementary.

2