For these reasons, we are justifiably confident about the strengths of America's financial industry. But we must not allow our confidence to spill over into a sense of complacency. As we have learned from experience, market over-confidence can lead to vulnerability. We must be vigilant as well toward issues such as lack of transparency, the risks that hedging strategies and models may not live up to their design, and the toxic combination of excessive leverage and illiquidity. As I have stated before, it is the private sector, not the public sector, that is in the best position to provide effective supervision and reduce the likelihood that these issues rise to a level that could threaten market stability.
Market discipline is the first line of defense in maintaining the integrity of our financial system.
In the past few years, the private sector has risen to meet the challenges posed by recent crises, and we have seen significant self-correction where excesses had developed. Individual institutions are taking steps to improve their risk management practices. Counterparties and creditors have more knowledge of their counterparts, more skill in evaluating risk and greater incentives than any public regulator will ever have. The best approach to regulation designed to address systemic risk is therefore to maximize the quality of counterparty discipline and to ensure that public activities do not crowd out the supervision provided by counterparties, creditors and investors. Second, by promoting the maximum degree of transparency, because transparency is the necessary corollary to counterparty discipline.