Financial reform needs to go beyond the banking sector on which so much attention has been focused. We also have to look very closely at non-bank financial institutions and at the set-up and functioning of financial markets. Leverage cycles, for example, have been a constant source of instability for centuries. If left to their own devices, their ultimate outcome has regularly been financial disruption, wealth destruction and economic hardship for our people. Let me start by elaborating first on risk before and after the crisis and then turn to monetary policy. I want to share with you the European Central Bank’s approach to dealing with the balancing act, in which we have sought a combination of bold action as regards nonstandard measures, while entirely preserving our clear focus on medium and long term price stability. Risk before and after the crisis Risk is inherent in economic activities because economic pay-offs are uncertain. Even the prototype model of finance – the competitive economy studied by Gérard Debreu and Ken Arrow – is subject to stochastic shocks. Therefore, economic returns are risky, because they are not known with precision ex ante. But the type of risk that we faced in the crisis was of a different nature. It was not triggered by stochastic variation in the real economy – by shocks to “endowments, technologies and tastes” as theory would predict. At source, it was financial risk.
Information sharing with other agencies is simply not as good as the intimate knowledge and understanding of markets and institutions that is  BIS Review 6/2010  5  gathered from first-hand supervision. Indeed, many institutions at the center of the crisis and arguably the most troubled – Bear Stearns, Lehman Brothers, Merrill Lynch, AIG and the GSEs – were not supervised by the Federal Reserve. Consequently, when those institutions came under stress, the Federal Reserve had poorer quality and far less timely information about the condition of these institutions than would have been the case if we had had the benefit of direct supervisory oversight. In fact, some of the hardest choices the Federal Reserve had to make during the most chaotic weeks of the crisis concerned systemically important firms we did not regulate. It is not surprising that, in the wake of the crisis, some countries that had separated bank supervision from the central bank monetary policy role are now reconsidering that division of labor. That is mainly because coordination problems created difficulties in responding quickly and effectively in the crisis. Separation made it more difficult to communicate in a timely way and to understand the broader implications of what was transpiring. It is critical that we not introduce new inefficiencies and impediments.