Let me focus on each of these three building blocks in turn, starting with banking. BIS central bankers’ speeches  1  I. Banking regulation and Basel III  Basel III, which constitutes the cornerstone of regulatory reform for the banking sector, provides for higher minimum capital requirements, better risk capture, a stricter definition of eligible capital elements with a particular focus on common shares and more transparency. The revised regulatory framework allows appropriate transition periods for financial institutions to adjust to the new standards, thereby ensuring a smooth phasing-in of the new regulatory requirements without compromising the nascent economic recovery. By 1 January 2015, the minimum capital requirements for common equity Tier 1 and total Tier 1 capital will gradually be raised up to a level of 4.5% and 6.0%, respectively. This gradual phasing-in of minimum requirements will be complemented by an appropriate observation period for the non-risk-based leverage ratio and the liquidity standards. The ESRB, together with the EBA, will play an important role in policy setting and implementation, with the former contributing to ensuring consistent implementation of the policy framework throughout the EU. We are just beginning that process. In addition to the necessary transposition into national or European law of the Basel III rules, there are two issues that still need to be addressed: systemically important financial institutions; and capturing the so-called shadow banking system within the regulatory framework. Work is in progress on systemically important financial institutions, in particular in the Financial Stability Board.
The main observation we have to draw from the crisis is that the risks in market returns were not mainly exogenous, coming from the stochastic variation in the real economy. They came from financial risk itself. The financial structures that we thought were in place to assess, absorb and neutralise risk were either dysfunctional or worked to magnify volatility. Key factors in creating this risk were opaque financial structures, particularly vulnerability to contagion and domino effects, and pro-cyclicality in financial markets. The lack of transparency in many financial instruments meant that some market players could exploit – for their own, private benefit – information that was not generally available. 2  BIS central bankers’ speeches  Pro-cyclicality acts as a formidable accelerator of financial trends. Two important factors that drive such amplification are distorted incentives and herd behaviour. The role of distortions in economic incentives is probably better known as it had traditionally been widely appreciated even within neo-classical modelling. By comparison, herd behaviour as a driver of pro-cyclical patterns in financial markets still needs a thorough explanation. It is difficult to rationalise herd behaviour. There are two possible explanations. One is the significance of a market player’s evaluation of his or her performance relative to the rest of the market. This is reminiscent of Keynes’ famous beauty contest analogy. To be successful in this environment, individual participants do not form their own opinions, but follow the general mood prevailing among market participants.