in doing this by the reserve bank and by the council of financial regulators which has regular discussions about system - wide developments. it is important that as the new rules are agreed and implemented, this strong focus on system - wide supervision is retained. the second issue – and one that has probably not received the attention that it deserves – is how regulation should deal with financial innovation. over many decades, our societies have benefited greatly from innovation in the financial system. financial innovation has delivered lower cost and more flexible loans and better deposit products. it has provided new and more efficient ways of managing risk. and it has helped our economies to grow and our living standards to rise. but financial innovation can also have a dark side. this is particularly so where it is driven by distorted remuneration structures within financial institutions, or by regulatory, tax or accounting considerations. problems can also arise where the new products are not well understood by those who develop and sell them, or by those who buy and trade them. over recent times, much of the innovation that we have seen has been driven by advances in finance theory and computing power, which have allowed institutions to slice up risk into smaller and smaller pieces and allowed each of those pieces to be separately priced. one supposed benefit of this was that financial products could be engineered to closely match the risk appetite of each investor. but much of the financial engineering was very complicated and its net benefit to society is debateable. many of the products were not well understood, bis central bankers ’ speeches and many of the underlying assumptions used in pricing turned out to be wrong. even sophisticated financial institutions with all their resources did not understand the risks at a microeconomic and system - wide level. as a result, they took more risk than they realised and created vulnerabilities for the entire global financial system. recently, a number of commentators have turned their attention to how society might improve the risk - return trade - off from financial innovation, in particular the question of how we obtain the benefits that innovation can deliver while reducing the risks. doing this is not easy, but a common thread to a number of the proposals is for greater public sector oversight of areas where innovation is occurring. there are considerable challenges here, but it is useful to think about how this might be done in practice. i suspect that the answer is not more rules, for it is difficult to write rules for new products, especially if we do not know what those new products will be, and the rules themselves can breed distortions

address the various problems. capital ratios are being increased, and the quality of capital is being improved. maturity transformation is being reduced. and banks are holding more liquid assets. these changes are occurring not just because of new regulations, but also because they are being demanded by the marketplace. together, these various changes are increasing the cost of financial intermediation conducted across the balance sheets of banks. in effect, the choice that our societies are making – partly through our regulators – is to pay more for financial intermediation and, perhaps, to have less of it. the benefit that we hope to receive from paying this higher price is a safer and a more stable financial system. this choice has a number of related implications, and i would like to mention just a couple of these. bis central bankers ’ speeches the first concerns lending spreads and the return on bank equity. in particular, loan rates are likely to be higher relative to short - term money market rates than would otherwise have been the case ; in effect, some of the incidence of the higher cost of financial intermediation falls on the borrowers. in addition, if banks are safer, then, all else constant, some of the incidence of high cost of financial intermediation should also fall on the owners of bank equity who should be willing to accept lower returns. but, of course, the story does not stop here. lower returns on equity are likely to increase the incentive for bank management to take on new risks in an attempt to regain earlier rates of return. lower rates of return may also lead to renewed efforts at cost cutting. this could have some positive effects, but if it were to involve cuts to the risk - management function, cost cutting could create new risks. and finally, to the extent that investors realise that credit and other risks are higher than they had previously thought, they might want more compensation for holding bank equity despite the efforts to make banks safer. these various effects are quite complicated and they will take time to play out. the one change that we have already seen very clearly is a rise in loan rates relative to the cash rate. for example, during the 10 years prior to 2007, outstanding variable mortgage rates averaged 150 basis points above the cash rate. today, this difference is around 270 basis points. this increase is due partly to the global loss of trust in financial institutions, which has led to all banks paying more for funds in capital markets. it is also due to the strong competition for deposits domestically, with banks