should make their uninsured creditors more risk sensitive and perhaps incentivize such institutions to better control their risk-taking. On the other hand, however, the significant expansion in deposit insurance coverage and lender-of-last resort facilities during the crisis raises the question of longer-term changes to their design. Some changes that have already been introduced are likely to become permanent such as, for example, higher deposit coverage and the elimination of the co-insurance component. This would blunt the incentives of depositors to monitor bank behavior. Moreover, the interplay between the new macro-prudential framework and safety net design – in particular, how to clearly demarcate the boundaries of safety nets under a broader regulatory perimeter and how to price them appropriately – is still undefined.

With regards to block 4, bank governance reforms have primarily focused on executive compensation plans, with international bodies developing principles and standards on sound compensation practices and asking national supervisory authorities and private firms to implement them<sup>21</sup> . A more important role for risk managers as well as greater independence, stronger qualification standards, and greater involvement in risk management issues by board members, are other regulatory solutions that may be introduced to address this problem. Providing a greater role to bank shareholders in executive remuneration and board composition matters has also been proposed, but it remains a controversial issue.

# **_Limitations and the Way Forward_**

Whether the proposed reforms are actually sufficient to address the failures of MD in this crisis can only be assessed in years to come – in fact, the true testing of the new framework can only take place once the crisis measures are rolled back and the regulatory reforms are implemented. However, it is unlikely that the reforms will be able to effectively address what is conceivably the greatest weakness of the concept, namely its inability to properly respond to the buildup of _systemic_ , as opposed to _idiosyncratic_ , risk in the financial system<sup>22</sup> . This topic has not been given sufficient attention in the MD literature, which has tended to focus primarily on assessing whether market participants are able to identify and punish individual weak banks. The financial crisis illustrates that MD cannot be relied upon sufficiently to tackle systemic risks in a preemptive way that would prevent the need for disruptive and costly _ex post_ market adjustments. It is therefore questionable whether proposals to involve market participants in pricing and/or providing insurance against systemic risks would be very effective, although a lot will depend on the nature of the incentives provided and their risk-sharing properties.

In fact, some commentators<sup>23</sup> argue that there is an inherent trade-off between MD and financial stability. Their argument is that even in an ideal world where all the building blocks of the MD framework work harmoniously together, the effectiveness of the concept is limited to mitigating idiosyncratic risks associated with principal-agent problems and moral hazard. This does not necessarily align the incentives of individual market players with those of the entire

> 21 See Financial Stability Forum (April 2009) and Financial Stability Board (September 2009) for details.

> 22 The corollary of this proposition, as stated by the U.K. FSA (March 2009), is that “ _it is quite possible, for instance, that efficient and liquid markets provide useful and accurate price signals as to the relative attractiveness of different equities or credits even if the overall level of prices is subject to irrational overshoots_ ”.

> 23 See de la Torre and Ize (February 2009) for a description of the characteristics and contrasting prudential implications arising from the existence of different financial paradigms. See also chapter 8 of Inter-American Development Bank (2004).

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