The Shadow Financial Regulatory Committee hosted a truly stimulating event today in which two ideas for helping to price moral hazard were introduced. The first would use prediction markets to help financial markets, calling on the Treasury to:
create a prediction market for bailouts of financial institutions… The “Failure Prediction Contract” (FPC) would be issued for individual large financial institutions, perhaps in proportion to their capital, and sold by the Treasury. It would pay out a pre-specified amount to investors in the event a bank fails, is bailed out or taken over by the government or the regulator, or receives any form of emergency credit support. The creation of such contracts would create incentives for financial regulators to enforce capital requirements in the first place.
The committee also floated the idea of catastrophe bonds:
An alternative suggestion is to require large financial institutions to issue a bond that does not have to be repaid in the event a bank fails, is bailed out or taken over by the government or the regulator, or receives any form of emergency credit support. This security is analogous to a catastrophe bond, except that its trigger event is a bank failure or government intervention. Such a security would have the added benefit of absorbing losses in a time of crisis.
A lot of the details would need to be worked out, but these are ideas that could be of interest to folks across the political spectrum.