Until the fog around banks’ capital adequacy is reduced, including regulatory-induced fog, banks’ cost of capital may remain high. Where next? Taken together, it is difficult to escape the conclusion that the current regulatory system, however well-intentioned, needs root-and-branch repair. The good news is that regulators internationally are increasingly coming to recognise that fact and have slowly begun the process of repair. In the past year, the Basel Committee has begun work to improve the “Simplicity and Comparability” of the regulatory framework. And earlier this year, the G20 Finance Ministers and Central Bank Governors committed the regulatory authorities to improve comparability of regulatory standards. The practical question is what might be done to improve the credibility of the framework? In the spirit of moving forward the debate, some possible practical ingredients include: (a) Greater transparency One simple way of alleviating some of the uncertainty around the existing regulatory framework would be through improved transparency, in particular around models and risk weights. Some encouraging progress has been made on this front recently. In 2012, the Enhanced Disclosure Task Force (EDTF) of the Financial Stability Board produced a set of recommendations for improved bank transparency. This included greater disclosure around the models used to calculate risk weights. At present, banks are at various stages of progress in implementing these EDTF recommendations. For example, a number of UK banks made good progress towards compliance in their end-2012 accounts. A firm future commitment by global banks to meet  3  8  With thanks to Jason Kravitt.

That seems a very difficult task to work out in my opinion. It implies that such rules would need to be designed to treat broad issues, such as increases in financial system leverage or aggregate credit growth, rather than more limited sectoral issues. This may work well in some circumstances in which the financial excess is occurring broadly, but might not be very effective when the problem, while extreme, may be more narrowly based. Historical experience suggests that past bubbles in the United States that have threatened financial stability have taken many different forms and affected many different sectors of the economy. Often, the bubbles have occurred in response to some important innovation in the economy or the development of instruments that facilitated real estate lending to lowerquality borrowers. Examples of these include the development of the internet in the technology stock boom of the late 1990s, and subprime lending and mortgage securitization innovations prior to the financial crisis. These innovations, in turn, sparked changes in belief systems that turned out to be false – such as, the rise in home prices reinforced the view that housing is an excellent investment and that national home prices can never decline. When the assumption that widely supports a boom is revealed as false, the consequence is often a sharp reversal in behavior and prices as the boom deflates quickly. I think it is very hard to anticipate these episodes and put rules in place that would limit such excesses.