The financial system may be out of intensive care, but it would be wrong to assume it has fully
 recovered. Major questions remain over how banks operate and how they are regulated. 
The solutions aren't always obvious, but they must be found if we're to avoid another crisis.

The financial system of the advanced market economies went into shock in August of 2007, 
and had a near-death experience after the bankruptcy of Lehman Brothers in September 2008. 
The extraordinary efforts by central banks and governments that were required succeeded in 
stabilising the situation and restoring more or less normal financial conditions. That is certainly 
good news. Moreover, the experience led to sharply increased efforts to foster financial stability. 
This is attested to by the recent publications by the Basel Committee on Banking Supervision 
and the Financial Stability Board in particular, and by the commitments made by the G20 in 
Seoul in November 2010. That is more good news. Finally, the pursuit of financial stability 
has focused ever more sharply on systemic interactions between parts of the financial system, 
rather than on just the health of the individual pieces. In short, still more good news.

Yet, recognising these substantial efforts should not blind us to remaining problems. First, we 
must accept the fact that financial stability, like price stability, is not sufficient to ensure 
macroeconomic stability. We must continue our efforts to improve the framework for the conduct 
of monetary and fiscal policies, in particular to ensure more aggressive policy tightening in the 
upswing of the credit cycle, and to pursue structural reforms to foster sustainable growth.

Second, and the topic I want to focus on here, the financial system still suffers from a host of 
problems. Some of these are immediate, like the continuing impact on banks' behaviour of 
low interest rates; others are longer term, such as the question of what to do with banks that 
are “too big to fail”. Regrettably, regardless of the timeframe, the solutions to many of these 
problems are by no means obvious.

Cheap rates obscure problems

Looking at the current situation, it is not at all clear that the policy efforts made to date have 
restored the financial systems of the advanced market economies to a state of rude health. 
Many banks face the need to roll over huge maturities in 2011 and 2012, and it is also not 
clear that capital levels-measured narrowly as equity-are adequate. The valuation of toxic assets, 
commercial and residential property, and now even the risk-free character of sovereign debt 
are all continuing sources of concern. Legal problems in the United States, not least about the 
adequacy of documentation of mortgage contracts, could also be a potential cause of significant 
future losses.

One way in which policymakers have contributed to the recapitalisation of the banking system 
has been to keep policy rates very low. This allows banks to fund themselves cheaply when 
investing in longer term instruments at higher yields. However, one has to wonder if the 
availability of such easy profits has allowed banks to avoid a more fundamental re-evaluation 
of their earlier, dangerous behaviour. With respect to dividend payouts, bonuses and momentum 
trading, for many banks in the wake of the crisis, it seems to have been a return to “business as 
usual”. Moreover, what of the longer term implications of low interest rates for insurance 
companies and pension funds? Unable to meet statutory or other commitments, will they turn 
to still more risky investments to “gamble for resurrection”? Or might they even renege on previous 
commitments leading to a widespread decline in consumer confidence?

Anyone riding the yield curve is also exposed to a sudden rise in long-term interest rates and 
associated capital losses. If this results from strengthening economic growth, then at least there 
is an offsetting source of profits and increased confidence in the financial system. However, if the 
rate rise is due to a sudden shift in inflationary expectations, or a loss of confidence in the prospects 
for debt repayment, the damage done may be harder to manage. In the United States, the particular 
problem of “convexity hedging”-a technique used by holders of mortgage-backed securities to 
protect their investments against interest-rate changes-implies that any rise in long rates there 
might be more sudden and violent than elsewhere.

Looking to the medium term, other problems loom. Some of these arise from the nature of the 
crisis itself, not least that it was centred in the advanced market economies. These have seen 
a massive increase in government deficits and debt, and there will be a great temptation to 
“stuff” this debt into the regulated part of the financial system, exposing these economies to 
even more of the dangers noted above. Moreover many emerging market economies, with their 
higher interest rates and lower sovereign debt levels, have already been the recipients of massive 
capital inflows and associated increases in asset prices. Should this also turn into a “bubble” 
that bursts, financial systems everywhere will surely feel the impact. In response to such concerns, 
many emerging markets have already moved to impose capital controls, and more of this might be 
expected.

Other problems in the financial sector are actually a by-product of the policy response itself. 
Four issues can be raised, all of which are significant.

First, some of the regulations being proposed or introduced might well have downsides for 
allocational efficiency. For example, forcing all OTC trades- direct “over-the-counter” trading of 
financial instruments between parties-onto exchanges would lose many of the benefits of 
customisation. Closely related, the fact that different countries often pursue national agendas, 
and sometimes introduce conflicting requirements for internationally active institutions, could well 
create problems going forward.

Second, uncertainty about how the regulatory agenda will play out, and how individual financial 
institutions might be affected, could be affecting the willingness to grant credit. This is of material 
importance for the robustness of the recovery itself.

Third, while the attention to “systemic risk” in the reforms proposed to date has been welcome,
 these reforms by no means go far enough. In Basel III, most of the proposals for more and better 
capital are directed at preserving the health of individual institutions. Thus, they have a microprudential 
character. The continuing distinction between different kinds of risk, when the essence of a systemic 
crisis is how one form of risk morphs into another, also indicates that a truly fundamental rethink 
about systemic risk still has to be carried out. Also, there has been a marked reluctance to date to 
tackle the “too big to fail” problem-in other words, the issues of size, complexity and 
interconnectedness of firms and sectors that are generally believed to increase the risk of systemic 
failures. Indeed, given the various mergers and acquisitions arranged during the crisis, it could be 
contended that these problems are now even bigger than they were before.

A fourth issue arising from the policy measures taken to date has to do with the possible 
diminished “independence” of central banks. Central banks have been allowed to operate 
independently to date because their actions were not thought to have distributional implications. 
Distributional issues are generally reserved for the political realm. However, many central banks 
during the crisis did make decisions with distributional implications-whose debt to buy or not buy, 
who to save or not save, and so on. Indeed, the decision to keep policy rates low constitutes a 
massive redistribution from savers to creditors. Taken together with the recognition that central 
banks, regulators and treasuries must, in the future, interact much more closely, both to help avoid 
and to manage financial crises, the meaning of the word “independent” is now even less clear than 
it was before.

Irrational exuberance

Even supposing we can deal with these medium-term issues, other problems will present 
themselves over the longer term. Financial crises have been with us since time immemorial and, 
bar highly repressive regulation, this state of affairs seems likely to continue. However, we can still 
take steps to minimise the damage arising from these periods of “irrational exuberance”. 
First, policy can “lean against the wind” more conscientiously, possibly by using both monetary 
tools and macroprudential instruments. Second, we should rethink how actively we use “safety nets”
-like ultra-low interest rates-in downturns. It could be that “little” downturns are actually beneficial, 
not least because they clear out the underbrush of debt and thus help to prevent bigger downturns 
later. And third, we should make adequate preparations in advance of financial crises to better 
manage them when they-inevitably-occur.

At the international level, there remains even more work to do than at the domestic level.
In particular, we need international agreements on resolution regimes for systemically important 
financial institutions, on how taxpayers might share the burden of debt in extremis, and agreements 
on international standards in a whole host of areas. There is no doubt that making such reforms 
happen will severely challenge the capacity of the current frameworks for international co-operation. 
Nevertheless, the effort must be made since the benefits would much outweigh the costs.



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