Interbank funding markets seized up, the shadow banking system crumpled and several major financial firms – banks and nonbanks alike – collapsed or approached the brink of collapse. Extraordinary interventions of governments and central banks around the world were necessary to prevent a complete collapse of the financial system and the broader economy. As a general matter, regulators did not appreciate beforehand how vulnerable the system was to shocks. In particular, there was a failure to appreciate the important interconnections among the banking system, capital markets, and payment and settlement system. For example, the disruption of the securitization markets caused by the poor performance of highly rated debt securities led to significant problems for major financial institutions. These banks had to take assets back on their books, backstop lines of credit were triggered, and banks could no longer securitize loans, thus increasing the pressure on their balance sheets. This reduced credit availability, which increased the downward pressure on economic activity, which caused asset values to decline further, and in turn, increased the degree of stress in the financial system. Moreover, regulators did not adequately understand how the dynamics of the system tended to exacerbate shocks, rather than dampen their impact. For example, with respect to capital, firms under stress had incentives to continue to pay dividends to show that they were strong. These dividend payments actually depleted capital, making the firms weaker and vulnerable to credit rating downgrades. When credit ratings were indeed cut, that increased collateral calls, which intensified the pressure on scarce liquidity resources.

The Committee on Payment and Settlement Systems and the Technical Committee of the International Organization of Securities Commissions are doing a review of standards for payment, clearing and settlement systems. This work will inform the efforts of the Financial Stability Board to strengthen such standards. There is also work underway on the problem of how to ensure that financial institutions have compensation structures that curb rather than encourage excessive risk-taking. Finally, it is critical that we ensure that no firm is too big to fail. This is about both fairness and having proper incentives in the financial system. Having some firms that are too big to fail creates moral hazard. These firms are able to obtain funding on more attractive terms because debt holders expect that the government will intervene rather than allow failure. In addition, too big to fail creates perverse incentives. In a too-big-to-fail regime, firms have an incentive to get large, not because it facilitates greater efficiency, but instead because the implicit government backstop enables the too-big-to-fail firm to achieve lower funding costs. BIS Review 14/2010  3  To solve the too-big-to fail problem, we need to do two things. First, we need to develop a truly robust resolution mechanism that allows for the orderly wind-down of a failing institution and that limits the contagion to the broader financial system. This will require not only domestic legislation, but also intensive work internationally to address a range of legal issues involved in winding down a major global firm.