It also includes developing a systematic framework so that banks can be required to raise capital to ensure that they have adequate resources to deal with adverse economic scenarios – even if those scenarios have a low probability of being realized. These innovations are designed to limit behaviors that we saw during the financial crisis that made the financial system less robust. Banks were reluctant to cut their dividend payments and compensation because of fears that this would signal weakness. These payouts depleted capital and made these institutions more vulnerable to deteriorating economic circumstances. Similarly, banks were reluctant to raise capital to protect themselves against particularly adverse states of the world. This was unfortunate because the collective behavior of banks to be less prepared for adverse states of the world, often made such adverse states of the world more likely. In an important sense, a poorly capitalized bank generates negative externalities, making the entire financial system less secure, with costs to other financial market participants, whereas the reverse is true of a well-capitalized bank. As noted earlier, another important step is to increase transparency throughout the financial system. There are at least two important elements to this. First, regulators need to have comprehensive access to information about the financial institutions and markets that they oversee – including ones that may not be directly regulated. Without such information,  4  BIS central bankers’ speeches  diagnosis of emerging problems is more difficult and less timely, and appropriate remedies are more difficult to develop.

As a consequence, at times, we must be willing to intervene to restrain financial booms in order to temper the busts.   Reform should be undertaken in ways that better align the economic incentives of participants in the financial system with the goal of financial stability.   We should strive to achieve a degree of transparency in the financial system that would enable market participants to make informed judgments about their financial market risks and exposures.   The core of the financial system – the major banks, non-bank financial intermediaries, and financial market infrastructures – must be made more resilient to adverse shocks and less susceptible to runs. BIS central bankers’ speeches  1    Recovery and resolution regimes must be effective in limiting the contagion to the broader financial system when major financial intermediaries or financial market infrastructures come under stress.   We must pay close attention to how all the components of the financial system interact. It can’t just be about particular institutions and infrastructures. Market processes and practices are also very important. Turning first to the issue of financial booms and busts, empirical observation makes it clear that financial markets are inherently unstable. Throughout history we have seen numerous sizable booms and damaging busts. The notion that financial markets are dynamically unstable is also supported by controlled experiments conducted by behavioral economists. Now I accept the notion that some minimum degree of instability is unavoidable.