Instead, the complement to that fraction – that which is due to excessive financial sophistication, abnormal risk tolerance and shortcomings in risk management – should be gone for ever. That is why my conjecture is that risk premia in a number of markets will continue to be reduced – but they are unlikely to reach the compressed levels that we saw prior to the crisis. Normalcy will probably be reached at a permanently higher level of risk compensation in a number of markets. In order to build an effective system of crisis prevention, we will all need to take on board this simple fact: compensation for risk will need to be appropriate. We shall prevent “pure” speculative activities from becoming the dominant force on the markets. And we shall build financial infrastructures with sufficient buffers to make them bulwarks against instability and resist shocks. Let me mention some striking facts about the power of such buffers. There is a widespread perception that banking crises in times when money was convertible into gold had apocalyptic consequences for bank depositors. This is not true. The estimated average loss on assets born by depositors in banks that were closed down as a consequence of financial  6  BIS Review 29/2010  crises was minuscule. Taking a yearly average between 1865 and 1920, it was six cents for every one hundred dollars of deposits. This time-frame covers five of the most severe episodes of financial panic in recorded history, most notably the 1907 crisis.
The financial structures that we thought were in place to assess, absorb and neutralise risk were either dysfunctional, or worked – perversely – to magnify volatility. This is how financial risk was created, transmitted to the real economy and eventually became systemic. Key factors in creating this risk were opaque financial structures, particularly vulnerability to contagion and domino effects, and pro-cyclicality in financial markets. The lack of transparency in many financial instruments meant that market participants did not know who was exposed to what kind of risk. In this state of incomplete knowledge, some market players could exploit – for their own, private benefit – information that was not generally available. 2  Neil Wallace (1981) has an early theorem on the ineffectiveness of open market operations. Gauti Eggertson and Mike Woodford (2003) prove the irrelevance of liquidity measures at times of zero interest rates. See Wallace (1981), “A Modigliani-Miller Theorem for Open Market Operations”, The American Economic Review, Vol. 71 No 3, pp. 267–274, and Eggertson, G. and M. Woodford (2003), “The Zero Bound on Interest Rates and Optimal Monetary Policy”, Brookings Papers on Economic Activity, 1, pp. 212–219. 2  BIS Review 29/2010  Pro-cyclicality acts as a formidable accelerator of financial trends. Demand for finance increases and declines in tandem with the cycle. But the supply of finance does not simply accommodate demand: it often amplifies the cycle. Where does pro-cyclicality stem from? To my mind, distorted incentives and herd behaviour are key explanatory factors.