Since Norges Bank will be providing the Ministry of Finance with concrete advice regarding a countercyclical capital buffer, I would like to devote some time to stating the reasons why such a buffer is necessary, and why, more generally, regulation of the banking sector is necessary. Then I shall touch upon the interaction with monetary policy and will also add some brief comments about some of the challenges facing monetary policy in the wake of the financial crisis. Why capital regulation? A well functioning financial market is essential for virtually all other economic activity in a market economy. Banks are a key component of the financial system. Banks channel money from savers to investors. Banks determine who should be given credit and closely monitor borrowers and their projects. This is a task that would be difficult for small savers to undertake. Resilient banks and prudent banking are important for a solid and stable economy. If banks end up with insufficient equity capital following substantial losses in bad times, they will have to tighten lending. This may serve to amplify the downturn, as is currently the case in a number of European countries. Compared with other enterprises, banks have limited equity capital. It is often more costly for banks to fund lending with equity capital than with deposits and borrowing from the market. As deposits are readily available to depositors and many deposits are covered by a deposit guarantee, depositors accept a relatively low interest rate.
It is well known that such systems can exhibit the following features: non linearity and discontinuities (a good example being liquidity freezes); path dependency; sensitivity to initial conditions. All this accounts for truly unpredictable behaviour. It creates uncertainty in the Knigthian sense: even with full knowledge of the "fundamentals" it may be impossible to associate a probability distribution to future states of nature. However, complexity creates the possibility of extreme events. It does not make them happen necessarily. Other factors may also contribute: one of them is human behaviour. 2. Financial systems are "human" systems. Their dynamic is shaped by the way human beings react to changes in their environment. Those reactions can help and amplify initial shocks to a point that a real "catastrophe" may occur. Herd behaviour has long been known as an essential feature of financial markets. More subtly, individual reactions, by themselves rational, can, by the virtue of their mutual interaction, produce strong amplification effects. This has been luminously shown by Danielsson and Shin in their seminal article on "endogenous risk", based on the now famous parable of the Millennium Bridge. Extreme events and modern finance With slight exaggeration, a case can be made that modern finance has been built, in practice, if not in theory, on implicit tolerance and widespread ignorance of extreme events. BIS Review 151/2008  1  The use of models Models are extensively used to assess risks and price assets. Nearly all models are based on the prevalence of "normal" (Gaussian) distribution as the basic tool.