I will not dwell here on the value and importance of capital adequacy standards in containing systemic risks – enough has been written on the Basel Accord and Basel II, such that this is well understood. However, consistent with my earlier comments on stress-testing and the importance of modelling behavioural responses, it is crucial the authorities understand banks’ likely responses to changes in minimum capital requirements over the business cycle. In this regard, the Bank and the Financial Services Authority (FSA) have recently developed a framework for monitoring the potential for procyclicality in credit conditions. The Basel Committee on Banking Supervision and the Committee of European Banking Supervisors are working on similar frameworks internationally. 2  Financial Stability Report (April 2007) (http://www.bankofengland.co.uk/publications/fsr/2007/fsr21.htm) & FS Paper No.2: “A new approach to assessing risks to financial stability” (Haldane, Hall and Pezzini) (April 2007) (http://www.bankofengland.co.uk/publications/fsr/fs_paper02.pdf)  2  BIS Review 77/2007  Capital adequacy standards are usefully complemented by “large exposures” rules. In particular, the application of such rules recognises the importance of addressing the risks from an unforeseen event that could cause a bank to incur serious loss, and that major problems could spill over from one bank to another given the network of interconnections. A European Union-wide review of the Large Exposures Directive is underway, offering the opportunity to improve the resilience of the financial system to such spill overs, including in the inter-bank market. Rather less has been written about liquidity buffers and prudential liquidity standards.

Taking a longer sweep, over the past 35 years cross border asset holdings having risen more than six-fold in terms of world GDP (Chart 4). Financial innovation has delivered considerable benefits. New products have improved the ability to hedge and share risks and to tailor financial products more precisely to user demand. That has enabled financial intermediaries and users of financial services to manage financial risks more effectively, and has lowered the costs of financial intermediation. And innovation and capital market integration have facilitated the wider dispersal of risks, which may have increased the resilience of the financial system to weather small to medium-sized shocks. Innovation has also delivered new challenges and vulnerabilities. Dependence on capital markets and on sustained market liquidity has increased, as banks and other intermediaries place greater reliance on their ability to “originate and distribute” loans and other financial products, and to manage their risk positions dynamically as economic and financial conditions alter. In turn that places additional pressure on the robustness of financial market infrastructure to handle large changes in trading volumes and to cope with periods of strain. And the greater integration of capital markets means that if a major problem does arise it is more likely to spread quickly across borders. So as highlighted by a number of academics and authorities, 1 the flip side to increased resilience of the financial system to small and medium-sized shocks may be a greater vulnerability to less frequent but potentially larger financial crises.