“ _Yes, the only place on earth where all places are, seen from every angle, each standing clear, without any confusion or blending_ ” _The full knowledge of a fact sometimes enables you to see all at once many supporting but previously unsuspected things._ Jorge Luis Borges, _El Aleph_ (1945)

# **I. Introduction**

The recent subprime crisis demonstrated that banking supervision and regulation are necessary to promote stable financial markets and support economic growth. The business of banking entails a wide array of risks, thus the purpose of supervision and regulations is that banks be prudently operated amid the associated risks involved.

Banks are by definition highly leveraged in that they operate with a high share of borrowed funds. Their ability to function on fractional reserves and the fact that they typically transform short-term funding into longer-term credits with greater risk amplify their vulnerability. The essence of leveraging borrowed funds to create potential high returns on investment creates an element of moral hazard in which the ultimate consequence of a negative outcome may not only be borne by the bank (limited to its equity at risk) but by its depositors as well. Besides, banks can also fall prey to systemic risks as a result of: i) debt inter-linkages with problem banks; ii) generalized bank runs triggered by investor panic; and iii) an asset implosion, causing a substantial drop in prices of stocks and/or real estate, as has recently been vividly illustrated in the US housing market.

This inherent frailty within the operational function of banks, the fact that they provide valuable “public goods” (access to the payment systems, savings intermediation, asset transformation, etc.), and the potentially large social costs derived from bank failures and spillover effects (into other banks and the real sector as well) motivate their regulation and supervision. Such financial distress and crises can come at a sizable cost to the economy with substantial losses that can run into double digit percentages of GDP.<sup>2</sup> The vexing events that followed the subprime crisis triggered a profound and comprehensive revision of the conventional approach to regulate and supervise financial systems. Championed by the Financial Stability Board and in response to the G20 Leaders’ call,<sup>3</sup> international financial institutions, standards setters, surveillance bodies, national regulators, and supervisors are elaborating and analyzing proposals to fix the features which have seemingly led to (or at least failed to prevent) the recent crisis.

> 2 Hoggarth, Reis and Saporta (2001) find that the cumulative output losses incurred during banking crisis periods are large, roughly between 15% and 20%, on average, of annual GDP. BCBS (2010a) surveys a wide array of approaches to measuring output costs from financial crises and finds that the median estimate of cumulative discounted costs is near 60%. Regarding the current crisis, Haldane (2010) estimates that the present value of output losses for the world economy can range between 90% and 350% of 2009 GDP, depending on what fraction of the 2009 loss is permanent.

> 3 As set forth in its _Washington Action Plan_ (see Group of Twenty, 2008) and its _Declaration on Strengthening the Financial System_ (see Group of Twenty, 2009).

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