In defense of the maligned market

NYU professor Viral Acharya says we need to be careful when we talk about the financial crisis being caused by 'the market' failing to function properly. Regulators are there to patch up holes and prevent problems, he says, "but regulation also reduces market discipline" by introducing distorted incentives.

For instance, insured depositors are unlikely to "run" but they also freely deposit at the highest-yielding bank, not worrying about its credit risk. Thus, when regulators deem a bank as well-capitalized, the onus is on regulators that this be right. Markets may not have the incentive to gather this information nor possess the details of regulatory supervision that led to such an assessment. Conversely, when regulation allows itself to be arbitraged, the financial sector becomes more opaque exposing markets to unexpected outcomes.