In general, our system relies on market discipline to constrain leverage and risk-taking by financial firms, supplemented by prudential oversight when government guarantees (such as deposit insurance) or risks to general financial stability are involved. However, the enormous losses and writedowns taken at financial institutions around the world since August, as well as the run on Bear Stearns, show that, in this episode, neither market discipline nor regulatory oversight succeeded in limiting leverage and risk-taking sufficiently to preserve financial stability.
What this suggests is a likely consensus among the Fed, Treasury, and Congress that market discipline (i.e., free markets) is not enough to ensure financial stability, and the current level of regulation is not sufficient to ensure stability. It is not accidental that this speech was titled, "Financial Regulation and Financial Stability."
So what would this new, enhanced regulatory regime look like? The Chair continues:
As part of its review of how best to increase financial stability, and as has been suggested by Secretary Paulson, the Congress may wish to consider whether new tools are needed for ensuring an orderly liquidation of a systemically important securities firm that is on the verge of bankruptcy, together with a more formal process for deciding when to use those tools. Because the resolution of a failing securities firm might have fiscal implications, it would be appropriate for the Treasury to take a leading role in any such process, in consultation with the firm's regulator and other authorities.
The details of any such tools and of the associated decisionmaking process require more study. As Chairman Bair recently pointed out, one possible model is the process currently in place under the Federal Deposit Insurance Corporation Improvement Act (FDICIA) for dealing with insolvent commercial banks. The FDICIA procedures give the Federal Deposit Insurance Corporation (FDIC) the authority to act as a receiver for an insolvent bank and to set up a bridge bank to facilitate an orderly liquidation of the firm. A bridge bank authority is an important mechanism for minimizing public losses from government intervention while imposing losses on shareholders and unsecured creditors, thereby limiting moral hazard and mitigating any adverse impact of government intervention on market discipline.