And, more fundamentally, should there be a Glass-Steagall type of provision to prevent retail deposits from being used to fund investment banking activities? There are good arguments in favour – to separate the utility functions of a retail bank taking household deposits and running the payments system from the casino trading of an investment bank, and good arguments against – the difficulty of maintaining a credible boundary between those institutions that are eligible to receive government support and those that are not. We need a public and informed debate on the merits of the arguments. We also should reflect on the fact that the belief that the authorities will step in when risks materialise encourages risk taking and means that risk-adjusted returns to financial activity are too high. The experience of unsustainably high returns in normal times interspersed by regular crises has been repeated across countries and over time. So if banks are to bear the true cost of the risks they take, changes need to be made to the environment in which banks operate. All these are important issues. While committing at international level to broad principles on regulatory reform, such as extending the net to all highly leveraged institutions and making capital requirements counter-cyclical, there is time to think through carefully the best way to implement them, and it is important that we take it. Many of these questions about the future of the regulatory structure will be discussed in the Turner review to be launched tomorrow. The Bank awaits the Review with interest.
Any shock could lead banks to fail through a domino effect. The superstructure of complex transactions within the financial sector (in derivatives for example) greatly increased this interconnectedness. The time-series aspect is the pro-cyclical behaviour of risk-taking in the financial system that I described earlier. Optimism feeds on itself until the occasional setback changes the mood to one of pessimism. And individuals are reluctant to accept that success may not be the  BIS Review 32/2009  3  result of superior wisdom, which should naturally be reflected in compensation, but the shortrun outcome of a risky strategy. To deal with the “cross-section” problems we need to reduce the exposure of the system to domino effects. For some, especially over-the-counter, markets this could be achieved by increasing the role of central counterparty clearing houses. Much good work on this is going on, led by the Federal Reserve Bank of New York. But a clearing house should not be an excuse for allowing flawed financial instruments, such as many of the mortgage-backed securities, to be treated as high quality assets. We also need to improve the regulation of the liquidity of banks. After the crisis began, the most striking feature of the regulatory system, as embodied in the Basel arrangements and implemented in the UK, was the absence of any effective regulation of liquidity. The FSA is acting to remedy the situation, and the Bank is in active discussion with FSA about how such regulation should best be implemented.