The implicit state guarantee for these institutions is a major source of incentive distortions. It is in complete contradiction with the functioning of a free market system and the hypotheses of our welfare theorems. Limited liability and the prevalence of bonus systems provide other significant distortions affecting individual decision-making. At various levels of financial institutions, decision-makers face asymmetric incentives. To give you an example, remuneration levels were high when risk taking paid-off, but there were no negative consequences – except possible job losses – when risks materialised. It is not surprising that excessive risk-taking was the consequence. 3  Domestic credit to private sector refers to financial resources provided to the private sector, such as through loans, purchases of nonequity securities, and trade credits and other accounts receivable, that establish a claim for repayment. Worldbank, World Development Indicators, http://data.worldbank.org/indicator/ FS.AST.PRVT.GD.ZS/countries/1W?display=graph. 2  BIS central bankers’ speeches  This problem of socially excessive risk-taking is even more damaging in the case of large interconnected institutions whose failure would endanger other institutions, with adverse consequences for the broader economy. Here, a clear externality is at work. My focus on incentive problems does not eliminate the possibility that cognitive or behavioural biases could also play a prominent role in driving excessive leverage in the banking sector. Herding behaviour and “group think” were certainly prevalent in “subprime investment”. A possible explanation for herding behaviour here is the propensity to suspect that “they know something that I don’t know”.

Jean-Pierre Danthine: Financial development – can we have too much of a good thing? Speech by Mr Jean-Pierre Danthine, Vice Chairman of the Governing Board of the Swiss National Bank, at the International conference on “Financial development, stability and growth”, jointly organised by the State Secretariat for Economic Affairs (SECO) and the Graduate Institute of International and Development Studies, Geneva, 25 October 2012. *  *  *  I would like to thank Claudia Strub and Till Ebner for their valuable support in drafting this speech. Introduction Typically, the term “development” has a positive connotation. A state of higher development is perceived to be superior to a state of low development. The same is true for the term “financial development”, which we associate with improved financial products, processes and institutions. Financial development leads to an improved allocation of capital, empowering entrepreneurs and facilitating risk bearing and consumption smoothing. All in all, financial development increases welfare and potentially promotes growth. As Schumpeter saw it, “Bankers are the gatekeepers of capitalist economic development. Their strategic function is to screen potential innovators and advance the necessary purchasing power to the most promising.”1 And, indeed, the pre-crisis economic literature on financial development was strongly influenced by King and Levine’s empirical study2 suggesting that “Schumpeter may be right”. Using data on 80 countries over the 1960–89 period, the authors concluded that the cross-county evidence was consistent with the view that the financial system promotes growth.