A collapse of confidence in the coffee houses of Lombard Street was one thing; a collapse of confidence in the world economy is quite another. An examination of these parallels will, I hope, help to throw light on three questions. First, does the nature of financial risk explain the frequency of crises and what does it imply for the design of banking regulation? Second, what are the lessons from the crisis for central banks in their pursuit of both monetary and financial stability? And, third and most urgently, how do we find our way out of the present crisis? The nature of financial risk and its implications for the regulation of banks There is no shortage of proposals for reform of bank regulation from official groups, such as the Financial Stability Forum, and unofficial groups, such as the G 30, chaired by Paul Volcker and the Geneva Forum. Since the excessive risk-taking of recent years has now given way to an extraordinary degree of risk aversion, there is no hurry to choose among them. Whatever exuberance – rational or irrational – existed has been destroyed by the crisis. So we have time to reflect before we decide on the shape of a new regulatory system. Another reason for reflection is that recent years have seen a natural experiment. Some regulatory systems were light touch, others heavy touch, and yet others placed both ownership and regulation of banks in the public sector.
And, more fundamentally, should there be a Glass-Steagall type of provision to prevent retail deposits from being used to fund investment banking activities? There are good arguments in favour – to separate the utility functions of a retail bank taking household deposits and running the payments system from the casino trading of an investment bank, and good arguments against – the difficulty of maintaining a credible boundary between those institutions that are eligible to receive government support and those that are not. We need a public and informed debate on the merits of the arguments. We also should reflect on the fact that the belief that the authorities will step in when risks materialise encourages risk taking and means that risk-adjusted returns to financial activity are too high. The experience of unsustainably high returns in normal times interspersed by regular crises has been repeated across countries and over time. So if banks are to bear the true cost of the risks they take, changes need to be made to the environment in which banks operate. All these are important issues. While committing at international level to broad principles on regulatory reform, such as extending the net to all highly leveraged institutions and making capital requirements counter-cyclical, there is time to think through carefully the best way to implement them, and it is important that we take it. Many of these questions about the future of the regulatory structure will be discussed in the Turner review to be launched tomorrow. The Bank awaits the Review with interest.