Strengthening market disciplines in the financial sector

This article discusses the role of market disciplines in the financial sector. It is a slightly amended version of a paper prepared recently under the auspices of the APEC Finance Ministers' forum, summarising the key points to emerge from an APEC conference on market disciplines and the role they can play in promoting financial stability. Market disciplines are an important element in promoting sound and efficient financial systems. In a well-functioning market, financial institutions with poorly developed risk management structures tend to be penalised by the market through higher funding costs, while those with prudent risk management structures tend to be rewarded. In the longer term, weaker financial institutions will be weeded from the system, leading to a healthier and more dynamic financial system that is better able to meet the needs of the wider economy. Unfortunately, many government interventions and policies tend to impede the effectiveness of market disciplines, such as widespread government ownership of banks, government guarantees of bank deposits, a presumption that insolvent banks will be rescued by the government, and poorly functioning financial markets. Weak market disciplines have been a major cause of financial crises in recent years in many countries, resulting in severe economic and social costs. This article discusses these issues and assesses the types of policies required to strengthen market disciplines. It also discusses the need to strike a sensible balance between promoting effective market disciplines on the one hand, while seeking to avoid the dangers associated with market over -reaction or extreme market volatility, on the other.