Conclusion

The recent turmoil in financial markets has provided many examples of why the structure of the microprudential, macroprudential, and market discipline is important. The recent experience serves as a reminder of old lessons in the area of microprudential regulation: the choice of regulatory structure is a crucial part of setting microprudential policy. If the structure of the prudential supervisor is based on something other than prudential regulation, prudential supervision is likely to receive lower priority than the other concern. For example, if microprudential supervisors are structured around subsectors of the financial system, especially small subsectors, the supervisor is likely to view preserving and expanding that subsector as more important than prudential supervision.

The recent experience also demonstrated that macroprudential supervision is necessary. Ideally, the macroprudential supervisors that come out of the current experience will be both bold and modest. They will be bold in their determination to understand the major risks facing their financial system, going wherever necessary to understand the nature and distribution of the risks. Given the global nature of the financial system, this boldness must extend to being willing to work with other macroprudential supervisors around the globe.

But all concerned also need to be modest in their expectations of what can be done. Macroprudential supervisors cannot guarantee an end to all financial instability, and trying to attain such a goal could be worse than having no macroprudential supervisor. A macroprudential supervisor trying to prevent all instability will have an incentive to severely limit the financial system's capability to innovate and to take risk. This will prevent the financial sector from fulfilling its resource allocation responsibilities. Further, when incipient instability appears, the macroprudential supervisor (and likely its government) will be under greater pressure to engage in bailouts to prevent or limit the instability.

Finally, the market discipline structure is also important. Supervisors cannot observe (and certainly should not second guess) every financial decision made by systemically important financial institutions. The managers of financial institutions and their investors must have adequate incentive to manage their risk exposures to keep them within reasonable limits. In order for this discipline to occur, managers and investors must believe that they are at risk of loss from inadequate risk management.

The key to credibly placing managers and investors at risk is setting up procedures that would allow systemically important financial firms to fail without a significant adverse impact on the financial system or the real economy. In this respect, the importance of a sound deposit insurance has come to be more widely appreciated, most notably with the post- Northern Rock reforms in the UK. There is also increased recognition of the merits of special resolutions procedures for systemically important financial institutions, including in the US, which has special procedures for chartered banks but not for other financial firms.

Even these measures are not likely to be adequate for handling a failing financial institution with substantial cross-border operations, however. Thus, serious consideration should be given to two additional measures. One of these measures would be to better plan for the resolution of systemically important groups by requiring the financial institution to develop a plan for its own resolution. Such a plan would be useful both for its home supervisor and in coordinating the resolution plans of the institution's home and host supervisors. The other measure would reduce the probability that a financial institution would become insolvent by obtaining contingent capital commitments while that institution is healthy that would recapitalize the institution if it becomes undercapitalized. The terms on which the private sector would supply such contingent capital would impose a cost on higher-risk institutions. Moreover, if the conversion is properly structured, it could impose significant costs on the shareholders and managers should the institution become so weak that it triggers the conversion.

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