Moreover, without strong covenants on existing debt, firms can raise additional funds without triggering defaults, which may decrease defaults in the short run, but perhaps increase them in the long run. In these cases, this “gloss” of confidence could cause a misallocation of resources, if companies or consumers without compelling prospects for full repayment nonetheless readily obtain credit.
I would like to use this opportunity to focus on what is in my view a crucial aspect of bank stability, namely, the existence of effective resolution mechanisms. Excessive risk-taking by banks is at the origin of the financial crisis. One of the many factors contributing to their risk-taking behaviour was the distorted incentive structure resulting from the lack of an effective resolution mechanism.