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.
Take a simple example of an investment that provides a long, regular stream of profits interspersed with occasional large losses, such that on average you would expect it to have the same return as a safe investment – not an unreasonable characterisation it would now appear of many of the investment strategies of recent years. Over short time periods, where it is unlikely that disaster will strike, it is more likely than not that investors will come out ahead, with a high return. But over long periods, where the risk that disaster will strike at some point is higher, it is likely that the overall return will be worse than the safe investment. And, because charges are often structured so that investment managers receive more of the upside from risky behaviour than they share in the downside, they have an incentive to promote the risky investment strategy. That, allied to a massive increase in the complexity of financial products and instruments in recent years, has meant that investors have, perhaps unwittingly, aided an enormous increase in the risks being run in the financial system. Given these problems, it seems to me that regulation should aim to be simple and robust. Overly complex measures of risk and capital adequacy are rarely robust to developments that are easy neither to anticipate nor calibrate. And robust rules for regulation will of necessity need to be simple or supervisors will be lost in a morass of unnecessary detail. For the same reasons we should not expect too much of regulation.