Creditors Should Suffer Too:

Tyler Cowen in today's NYT:

even smart and honest regulators can monitor a financial firm only so well. A firm's balance sheet doesn't always reflect its true health, and regulators do not have an inside perspective on the firms they are supposed to secure. We do need more effective regulation, but calls for regulators to "get tough" are likely to prove effective only as long as a crisis lasts.

What the banking system needs is creditors who monitor risk and cut their exposure when that risk is too high. Unlike regulators, creditors and counterparties know the details of a deal and have their own money on the line.

But in both the bailouts and in the new proposals, the government is effectively neutralizing creditors as a force for financial safety. This suggests a scary possibility — that the next regulatory regime could end up even worse than the last.

The more closely a financial institution is regulated, the more it will be assumed that its creditors enjoy federal protection. We may be creating a class of institutions whose borrowing is, in effect, guaranteed by the government.

It doesn't need to be this way.