A concrete example of the merits of financial integration is how the arrival of foreign banks resulted in a rapid development of the banking systems in the Eastern and Central European countries. The citizens and corporations of these countries benefitted substantially from early access to advanced financial services. The second solution – to create an international institution with taxation rights or a system of ex ante burden sharing – is simply not realistic for the foreseeable future. 4  BIS Review 118/2009  Consequently, we are stuck with the geographical mismatch and, as a consequence, crossborder banks pose a real challenge to crisis management. To accommodate this mismatch, national authorities must cooperate more effectively. This is the only feasible option. In order to achieve efficient cooperation, it is vital to build trust between authorities, which explains my third ingredient. In the EU, we have the home country principle as a fix for the geographical mismatch. We have also signed a European Memorandum of Understanding (MoU) aimed at improving cross-border cooperation. However, the home country principle does not solve the dilemma of international banks and national authorities. Tension arises because the home country is responsible for the supervision of branches but the host country is responsible for the financial stability of the country. This tension also persists if the foreign bank operates through subsidiaries. Many cross-border banks centralise different parts of management. There are good economic reasons for such centralisation.
We – at the Riksbank – have been publishing stress tests of individual banks since 2006. With a track record of reasonable stress tests, the credibility of the methodology and the results has continued to increase during the crisis. Building confidence in the long-run: liquidity and capital regulation The financial crisis of the past two years has been very costly. We must ensure that this crisis does not repeat itself. Lawmakers, central banks and financial regulators have a daunting task ahead of them. Regulatory and supervisory reform is needed. I have great hope that we will take this opportunity to create a safer and sounder financial system. In this respect, I would like to bring up two important issues for a safer financial system: liquidity and capital regulation. Liquidity or, rather, illiquidity has been in the centre of this crisis. Banks will always be exposed to liquidity risk due to the maturity mismatch, as this is a central feature of banking. However, in the run up to the crisis, this maturity mismatch increased too much. Banks relied on the misguided perception that short-term financing would be available from liquid markets. A key lesson from the crisis is that a liquid market can very quickly become illiquid. The conclusion is that liquidity must be regulated more firmly. Banks need to hold a buffer of liquid assets large enough to allow them to weather a liquidity shock.