2  BIS central bankers’ speeches  When leaning against the wind of the credit cycle, macro-prudential authorities do, like their monetary policy colleagues, still need to find the optimal path. To use the words of the UK Chancellor, their objective is not to ensure “the stability of the graveyard”. How they balance cost and risk, where they set the trade-offs, will depend in large part on how confident they are about the underlying resilience of the system – in other words how well they have done on the first impulse. International governance The second big change I want, therefore, to highlight is the development since the crisis of much stronger international governance. This stems from the creation, at the April 2009 G20 London summit, of the Financial Stability Board (FSB). And, equally important, from the decision at the Summit that the FSB should report directly to the G20 Leaders and Finance Ministers to give it the necessary “clout”. Working with the standard setting organisations like the Basel Committee, the FSB has provided the drive and coordination to reform and develop global standards for bank capital, liquidity, and resolution. If one remembers the best part of a decade that it took to develop and reach agreement on the Basel 2 capital standard, the progress made and international agreement reached over the past 5 years has been extraordinary.
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.