If assets market are booming and perceived returns are high, banks will always find the necessary capital. Conversely, capital dries up during downturns, when it is most necessary. Introducing counter cyclical capital requirements will certainly help. But we may not have looked enough into the interrelated dynamics of stock and credit markets; or, put differently, on how capital flows in and out of the financial sector during different phases of the economic cycle and what are the consequences on credit flows. Finally, tailoring capital requirements to the definition of economic capital by banks themselves strengthens the incentive function. But from, a macroprudential perspective, by replicating closely private risk management methods and metrics, this encourages uniformity in behaviour, which, by itself, is a source of instability. It is becoming increasingly clear, it seems to me, that if we want prudential supervision to effectively pre-empt the build up of imbalances, it has to act more directly on individual and collective incentives. This should push us to look more closely at the "accountingcompensation" nexus. When looking at revenues drawn from a financial investment, it is generally impossible to distinguish excess return from additional risk taking. Ignorance of tail risk fits perfectly in this framework. This points to a possible solution: regulatory systems should force the pricing of risk in all its dimensions, including liquidity risk. Again, there is a clear analogy with tax theory: "internalizing" the risk eliminates market failures. The conceptual challenges in quantifying, for instance, liquidity risk, are enormous.
Jean-Pierre Landau: Bubbles and macro prudential supervision Remarks by Mr Jean-Pierre Landau, Deputy Governor of the Bank of France 1 , at the Joint conference on “The Future of Financial Regulation”, organised by the Bank of France and the Toulouse School of Economics (TSE), Paris, 28 January 2009. *  *  *  Looking at the future of financial regulation is specially challenging in the current juncture. Right in the midst of the crisis, we cannot be sure that we fully understand its ultimate causes, its roots, and its dynamics. Furthermore, we do not want to be fighting the last war. We need a vision on how the financial system will evolve in the future, something very difficult to figure out right now. And yet, there is a strong political demand for orientations and measures to fix the problems and make sure they never happen again. This demand is fully legitimate, considering the social costs that the crisis is imposing on our societies, and more specifically, the financial burden taken on by tax payers. I have chosen to present some remarks on bubbles and macro prudential supervision. They should be seen more as a work program than a full-fledged answer to the many questions raised for the future. I will deal with three issues: what are we trying to achieve? What are the main challenges? Which are the proper instruments? What are we trying to achieve? Here, we have two certainties, and many questions.