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Prudential Discipline For Financial Firms: Micro, Macro, And Market Structures

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Executive Summary

The recent global financial crisis reflects numerous breakdowns in the prudential discipline of financial firms. This paper discusses ways to strengthen micro- and macroprudential supervision and restore credible market discipline. The paper argues that the primary responsibility for risk management must rest with firms, not with government supervisors. Unfortunately, systemic risk concerns have led governments to shield the private sector from the full losses that dull their incentive to discipline risk taking. The paper suggests that deposit insurance reform, special resolutions for systemically important firms, and requiring firms to plan for their own resolution and contingent capital may all have a role to play in restoring effective market discipline.

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