There are in short negative externalities. BIS Review 83/2007  1  As you all know, the impact of industry emissions on the environment is the classic example of what we economists call negative externalities. If the market is left without any intervention at all, the costs for the pollution will be borne by others than those who have actually been directly involved in the polluting business. The same reasoning can be applied to financial crises. A crisis that severely affects the functioning of the financial system will cause substantial costs to the entire economy, ultimately in the form of loss of output. These costs go far beyond what the financial firms can possibly take – or are willing to take – into account when conducting their day to day business activities. Both with regard to pollution and financial crises there are ways to manage the negative externalities. Public interventions can be used so that the negative externalities are internalised in a way acceptable to society as a whole. For industries polluting the environment, authorities can for example impose taxes or issue emission rights to compensate for the social cost of pollution. For banks and financial firms this is achieved by regulatory and supervisory measures, such as capital requirements and rules for the establishment and conduct of business as well as provisions giving central banks the right to grant emergency liquidity assistance. Many stakeholders, but no single authority If the negative externalities are limited to a national scale, sufficient public intervention may be possible.

In my country we have painful experiences of a banking crisis that occurred partly because the new deregulated environment posed new challenges for banks as well as for regulators; challenges they were not prepared for. Eventually banks developed more appropriate risk management techniques and supervisors adopted a more risk- and process-oriented form of supervision rather than the previous rather formalistic type. This has clearly lowered the risk of financial crises. Internationalisation of banking Also after the deregulation, most banks have remained predominantly national. Only in the last decade have we seen the emergence of some big cross-border banks with major activities in several countries. And this financial integration is accelerating. Let me here be perfectly clear. This development is positive for the economy. It stimulates competition and product development across countries. It also means that the banks can profit from economies of scale and scope. The spread of cross-border banking has reached different levels in different parts of the world. In Europe it has been increasing rapidly in the last few years, but there are also several active cross-border banking groups here in the Pacific region. This integration is not without challenges. In particular supervision and crisis management arrangements have to be addressed hopefully with some foresight, before we get another crisis. To explain this allow me to draw a parallel to the perhaps most burning issue in contemporary debate; the problem of global warming and climate change. The challenges of financial integration share some of the same characteristics as the environmental problems facing us.