A Program for Financial Stability

While the collective judgment of markets can sometimes make a mistake in valuing a financial instrument, it can be quite risky to rely instead on the judgment of a small group of individuals who claim to know the market is wrong. When a government guarantee creates an opportunity to profit from taking risks that are partially borne by taxpayers, competitive markets will rush toward that opportunity, as well as deprive resources to other sectors that could put them to better use. The market discipline that is lost when insured creditors do not feel themselves to be at risk must be replaced by official regulation and supervision. However, we shouldn’t rely too heavily on our ability to offset the effects of explicit and implicit safety net guarantees through more strenuous regulation. Instead, there are several ways to use market discipline to constrain the risk-taking of large financial institutions and improve the stability of financial markets: (1) re-examine bankruptcy law and look for ways to improve its effectiveness for stressed financial firms and reassure policy authorities; (2) rigorously implement the Dodd-Frank provisions that require credible resolution plans (living wills) for large financial firms; (3) further restrict the means available to use public funds to rescue private creditors, which would improve the credibility of a commitment to greater market discipline; and (4) remove legal or regulatory impediments that prevent financial intermediaries from reducing their vulnerability to financial shocks.