Abstract
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.
Highlights
The severity of financial crisis of 2008 and its spread throughout the world at an alarming speed shocked everyone
Regulations, prudential supervision and ethical grounding are needed for preventing future financial crisis
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
Summary
The severity of financial crisis of 2008 and its spread throughout the world at an alarming speed shocked everyone. In the US, Dodd-Frank Act established the Financial Stability Oversight Council (FSOC) to identify risks and suggest measures to prevent another financial crisis. Such comparison is inappropriate since parts of a machine do not negotiate with each other the terms and conditions of engagement and no part of a machine ever displays moral hazard or strategic behavior but people, who are the primary constituents of an economic system, do Anyhow, such comparison was harmless, though inappropriate, to treat the baker, the barber and the butcher as parts of a machine but it could be disastrous since it diverts attention away from the source of systemic risk. Sihag 354 probably have become lax and not keen on guarding against the risky behavior of bankers and others That is, it has become, in addition to FDIC and unemployment compensation, another case of moral hazard problem.
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