The World Bank Latin America and Caribbean Region Chief Economist Office

The Policy Research Working Paper Series disseminates the findings of work in progress to encourage the exchange of ideas about development issues. An objective of the series is to get the findings out quickly, even if the presentations are less than fully polished. The papers carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the views of the International Bank for Reconstruction and Development/World Bank and its affiliated organizations, or those of the Executive Directors of the World Bank or the governments they represent. Policy ReseaRch WoRking PaPeR 4842 The Subprime crisis resulted from the interplay of information asymmetry and control problems with failures to internalize systemic risk and recognize the implications of Knightian uncertainty. A successful reform of prudential regulation will thus need to integrate more harmoniously the three paradigms of agency, externalities, and mood swings. This is a tall order because each paradigm has different and often inconsistent regulatory implications. Moreover, efforts to address problems under one paradigm can exacerbate problems under the others. To avoid regulatory arbitrage This paper—a product of the Chief Economist Office, Latin America and Caribbean Region—is part of a larger effort in the region to identify and examine the policy lessons from financial crises. Policy Research Working Papers are also posted on the Web a