safely and soundly, the united states has developed an extensive system of banking supervision and regulation. in effect, regulators assumed the role of monitor, the role that insured depositors no longer have any incentive to play. somewhat ironically, however, this system of government supervision may itself exacerbate moral hazard if the banks ’ uninsured creditors assume that the government ’ s oversight obviates any need for them to monitor banks. market discipline may erode further if market participants believe that, to avoid the risk of a financial crisis, the government will step in to prevent the failure of any very large institution – the “ too big to fail ” problem. with little or no help from market forces, the burden of ensuring banks ’ soundness falls entirely on the supervisory agencies. but as we saw in the savings and loans crisis of the 1980s, regulatory oversight may also fail if the regulators are not sufficiently vigilant or lack the political will or financial resources to promptly close insolvent institutions. the lesson of history appears to be that neither market discipline nor regulatory oversight alone is completely adequate for keeping the banking system safe and sound. however, regulators have increasingly come to appreciate the value of a hybrid system that supplements direct regulation with a federal reserve act, december 23, 1913. substantial amount of market discipline. fortunately, regulators have a variety of ways to restore and strengthen market discipline for banks, notwithstanding the existence of the federal safety net. minimum capital requirements are one method. a bank ’ s capital provides a buffer that can absorb losses before they fall on the deposit insurance fund ( and, ultimately, the taxpayers ). in addition, however, capital requirements enhance market discipline ; they do so by ensuring that the bank will have shareholders ( and possibly other types of creditors as well ) who have a significant amount of money at risk. these shareholders have a substantial financial incentive to monitor the bank ’ s activities and to insist on changes if they are dissatisfied. bank managers are also quite aware that a low share price could invite a hostile takeover, an outcome they usually want to avoid. the incentives for a bank to control risk are even stronger if regulations link the amount of regulatory capital to the risks taken by banks. ( tying capital requirements to risk is a primary objective of the basel ii capital accord, currently in the process of review and implementation. ) risk - based capital regulations, if properly designed, require banks that take more risks to hold more capital. because equity capital is the most expensive form of funding

bank uses to raise funds can matter. for instance, holders of uninsured debt ( such as large certificates of deposits or corporate debt issues ) care mostly about the risk of bankruptcy. they don ’ t benefit if the bank ’ s stock price rises when undue risk - taking pays off. consequently, they focus on what bank managers are doing to avoid default. the incentive to monitor risk - taking is particularly keen for holders of subordinated debt, as they are last in line in the event of failure. because debt holders are sensitive to changes in the probability of financial distress, risk - taking by a bank raises its cost of funding in credit markets, and that connection creates an incentive for banks to control risks. moreover, the price of a bank ’ s debt provides useful information the least - cost - resolution requirement can be waived if a determination is made that adherence to it will create a systemic risk ; however, this exception was intentionally made quite difficult to invoke. about the bank ’ s riskiness. with that information, the bank ’ s counterparties and supervisors can take steps of their own to ensure that the bank is operating safely. 3 hedge funds hedge funds provide a second illustration of how the invisible hand can be used to support regulatory objectives. their rapid growth is one of the most important developments in u. s. financial markets in the past decade or so. hedge funds vary widely in their investment strategies and in the types of risks they take. overall, however, most economists agree that the rise of hedge funds has been a positive development for investors and for financial markets. they have stimulated an extraordinary amount of financial innovation in recent years ; and, using many of these new financial tools, they have greatly enhanced the liquidity, efficiency, and risk - sharing capabilities of our financial system. regulatory oversight of hedge funds is relatively light. because hedge funds deal with highly sophisticated counterparties and investors, and because they have no claims on the federal safety net, the light regulatory touch seems largely justified. however, the growing market share of hedge funds has raised concerns about possible systemic risk. the complexity and rapid change inherent in the strategies of many funds make them relatively opaque to outsiders, and so the concern arises that the collapse of a hedge fund might come with little warning. in addition, many hedge funds are either highly leveraged or hold positions in derivatives or other assets that make their net asset positions very sensitive to changes in asset prices ( the functional equivalent of high leverage ). highly leveraged