The theory and practice of financial stability

This paper reviews sources of market failures in financial institutions and markets and what can be done to alleviate them. It examines game theoretic explanations for financial instability, in particular the role of asymmetric information in generating destabilising behaviour. Parallels are drawn between the forces that can lead to a crisis in financial institutions and those that make for price volatility in asset markets. In the area of remedies, the paper analyses the potential contribution of official 'safety-nets' and what can be done to minimise the associated moral hazard. In this context, it discusses the role of regulation and enhanced transparency. Lastly, the paper discusses techniques for stabilising asset prices in markets.