Independent central banks appeared to have tamed inflation once and for all. New sophisticated financial instruments seemingly succeeded in reducing risks to low levels for ever. A new generation of investors emerged and took on risks that they could not afford. Cross-border transactions increased rapidly at unprecedented levels. After a period of several good years, euphoria emerged at the beginning of the 21st century. The focus on return on equity (short-term) rather than on return on assets (long-term) provided wrong incentives for the owners and the managers of banks. Whereas in 1998 the detaining period for shares in a bank was three years on average in the US and in the UK, it decreased to 3 months in 2008, signalling the so-called “casino capitalism”. At the same time, while in 1989 the executive directors of the top seven US banks gained 100 times the average income of a median household, by 2007, they earned 500 times that income. This disregard for risk sparked worries among the national and international authorities concerning potential threats to macroeconomic and financial stability. The interest in macroprudential policies, which nowadays are seen as vital, became manifest early in the `80s. However, policy implementation remained feeble and the unthinkable happened. Now the most important mission is to correctly identify what went wrong and what principles we should use when making enhancements to our financial system. Before moving on to the next section which addresses these issues, let me draw two lessons. First, overregulation is not good.

The situation is similar in substance in Europe, where new regulatory directives and regulations account so far for 2,000 pages of primary legislation, and where detailed rule-making occur on a similar scale as in the US, we would end up with 60,000 pages for a now literal regulatory blanket. Today’s financial markets are very complex and are becoming even more so. Haldane and Madouros are right: “as you do not fight fire with fire, so you  4  BIS central bankers’ speeches  don’t fight complexity with complexity”. An efficient regulatory response should be grounded in simplicity. The “keep it simple” principle has never sounded truer. III.2. Fixing the financial system  Attempts to fix the financial system seek to alter its structure by dealing with the scope, the size and the cross-border dimension of the financial activity. As concerns the scope, the basic idea is that financial institutions should be prohibited from undertaking certain potentially risky activities. Some proposals recommend reintroducing the separation between commercial and investment banking (as in the original Glass-Steagall Act). Others, such as the so-called “Volcker rule”, distinguish between client-service trading and proprietary trading, basically banning the latter. Criticism of these proposals is three-fold: (i) the separation between commercial and investment banking is much more suitable to remove a conflict of interests rather than reduce credit risk; (ii) the major risk for commercial banking is, after all, credit risk; and (iii) in practice, it is difficult to delineate between proprietary trading and trading to hedge risk.