For example, the Basel Committee published a framework to identify optimal levels of bank capital and used that framework as an input into the calibration of Basel III capital requirements.10 This approach considered how the probability of a financial crisis varies with bank capital, the social costs of banking crisis, the link between bank capital and bank funding costs, and the impact of higher loan spreads on economic activity. Moreover, this efficient frontier is not fixed and is likely to vary over time as technology, official sector tools, and bank business models evolve. For example, technology-driven innovations that rely on bigger datasets and more sophisticated predictive algorithms might change the risk/return opportunities associated with certain intermediation services. Similarly, supervisory innovations like stress testing or more sophisticated horizontal assessments could make official sector oversight more effective. Finally, changes in business strategies like a shift to a more diversified business model might change the overall risk of certain activities. One can think of these changes as shifting the efficient policy frontier where there is more intermediation for a given level of risk. Alternatively, constraints on supervisory authorities or practices could shift the frontier in the opposite direction if use of effective tools is prohibited. Given the complexity of these relationships, it is not surprising that there is a wide range of estimates and theories about the optimal type and level of oversight of financial institutions. Nonetheless, we need to understand better these relationships in order to make policy choices more effective.

In this context, the risk of disruption or a financial crisis matters because of the potential reduction of necessary financial services and economic activity in the future. As I discussed in a talk at this conference a few years ago, a short-term discussion of the balance between firm resilience and the provision of financial services may be reframed over a longer horizon as a dynamic trade-off between the provision of financial services today and in the future.5 This risk/return framework extends that perspective if one cares about the volatility of those financial services across different states of the world and over time. The idea of multiple objectives suggests a policy trade-off with an efficient frontier. In this framework, an efficient financial sector regime can only realize more intermediation if it accepts a higher risk of financial instability and less intermediation in the future. A second premise is that the official sector can impact outcomes relative to this frontier through a combination of rules, regulation, and supervisory policies. For example, a reduction in loan documentation requirements, risk management reviews and supervisory oversight might allow increased lending in the short-run, but potentially lowers loan quality and increases risk over time. A particular set and calibration of policies is efficient if the only way to increase financial intermediation is to accept higher risk of disruption or crisis. Equivalently, an efficient outcome is one where the only way to reduce risk is to accept less intermediation.