This provides a telling example of the perverse incentives that the Draghi Report had highlighted a decade earlier. Booking practices and pricing were distorted by lax overall regulatory capital requirements, a zero-weighting on 364-day committed lines to shadow banks, accounting regimes that recognised unearned profits on highly illiquid securities, and an implicit state subsidy to housing finance from public agencies that were themselves over-levered and profit-maximising. Policy responses and lessons Looking back, armed with these conjectures, what could or should have been done as our economy and others accumulated debt? A few years ago, a couple of us discussed this in the margins of a regular gathering of economists in London.21 One thought was that Western governments should have “gone on the biggest infrastructure splurge since Victorian times”, spending the inflows on investment rather than consumption. I can’t help wondering whether all the investment would have been well judged. Another thought was that the UK and others should have tightened fiscal policy, in order to raise national saving and so improve our external position. That would have added to global saving, possibly pushing the world real rate lower, asset prices higher, and so possibly further fuelling private sector borrowing. But were we trying to answer the right question that evening?
I think that Basel II recognizes the importance of a combination of micro and macro factors for achieving greater financial stability. Furthermore, I would say that Basel II incorporates some of the key basic principles that are also built in modern approaches to monetary policy: a flexible and forward-looking approach, anticipatory rather than reactive behaviour to risk, and the need to take into account market views. Looking into the future, we must direct our resources to ensure that banking supervision in the 21st century is more dynamic, more preventive, more flexible, more inclusive, and more transparent. We should continue adapting and learning. I believe the ultimate objective of financial stability increasingly requires co-operation and properly aligned incentives on the part of the industry, markets, and supervisors. Thank you. BIS Review 34/2005  7