Author: Balbir S. Sihag
In the wake of the recent Great recession of 2008-9, prudential supervision and “too-big-to-fail” have become the focal topics of discussion and policy. Western countries have added prudential supervision to complement the traditional regulatory approach to prevent reoccurrence of financial crisis. Additionally, large financial institutions are subjected to repeated “stress tests” to diagnose the vulnerability of the financial system. Kautilya had argued a long time ago that moral failure was the primary source of the systemic risk. Keeping that in view, relevance of his three insights is presented. Firstly, regulations, prudential supervision and ethical grounding are needed for preventing future financial crisis. That is, current approach of relying only on regulations and supervision, most probably would not prevent future financial crisis. Secondly, if moral hazard resulting from moral failure is the primary source of systemic risk, undue focus on “too-big-to-fail” financial institutions is unwarranted. Thirdly, Financial Stability Oversight Council’s two objectives, promoting market discipline and prevention of another financial crisis, do not seem to be compatible with each other.
See also: Comments to Paper