short run is actually highly risky in the long run. as in monetary policy, it is unlikely that prudential supervision can be implemented as a set of rules to be applied mechanically. nevertheless, to rely solely on the discretionary judgment of individual bankers and regulators is asking too much of human capabilities. this suggests that the principle of constrained discretion, applied so successfully in monetary policy, needs to be applied to banking regulation. that is not to say that a similar institutional apparatus would be appropriate, but we need to build into the system some simple and robust impediments to excessive risk - taking that can be monitored. and we must ensure that an institutional memory is maintained so that the lessons from the crisis are not forgotten and those impediments to excessive risk - taking are not swept away once memories of the crisis recede. the design of those impediments should be based on an explicit identification of the market failures that regulation can hope to correct. such market failures seem to relate to two dimensions of banking – the “ cross - section ” and the “ time - series ” aspects of behaviour. the former reflects the extreme interconnectedness of banks. each individual institution can appear relatively safe while the links between them mean that the system as a whole is vulnerable. any shock could lead banks to fail through a domino effect. the superstructure of complex transactions within the financial sector ( in derivatives for example ) greatly increased this interconnectedness. the time - series aspect is the pro - cyclical behaviour of risk - taking in the financial system that i described earlier. optimism feeds on itself until the occasional setback changes the mood to one of pessimism. and individuals are reluctant to accept that success may not be the result of superior wisdom, which should naturally be reflected in compensation, but the shortrun outcome of a risky strategy. to deal with the “ cross - section ” problems we need to reduce the exposure of the system to domino effects. for some, especially over - the - counter, markets this could be achieved by increasing the role of central counterparty clearing houses. much good work on this is going on, led by the federal reserve bank of new york. but a clearing house should not be an excuse for allowing flawed financial instruments, such as many of the mortgage - backed securities, to be treated as high quality assets. we also need to improve the regulation of the liquidity of banks. after the crisis began, the most striking feature of the regulatory system, as embodied in

protections and powers for the achievement of a clear statutory objective established by the legislature. bailin is not about a specific type of bond – a so - called ‘ bailin bond ’ – but about the application of a statutory resolution power to bonds of any kind within a statutory resolution. ‘ bailin ’ is a verb not a noun. orderly resolution will not be achieved by drafting term sheets. bis central bankers ’ speeches looking back on the 2007 – 2009 part of the crisis, those precepts should have been in place anyway. in the uk, it was alarming that many medium - sized domestic banks had been allowed to hold each other ’ s bonds in what were purportedly ‘ liquidity ’ portfolios. 9 contagion ( 2 ) : the creditor hierarchy and depositor preference preparations for bailin, and even more the recent reconstruction of cypriot banks, have heightened awareness of the prospect of creditors of distressed banks losing money, prompting calls for clarity about the relative standing of different types of creditor. who stands where in the creditor hierarchy affects the loss they incur in the event of default, and therefore their behaviour before default, including the return they demand to compensate for risk and whether they flee at the first signs of the firm weakening. insured depositors are insured, pure and simple – they are covered by the relevant deposit guarantee scheme. the details of the resolution regime do not affect that. 10 nor does preference for insured deposits affect those depositors directly. rather, it affects the exposure to loss of the dgs and thus the share of the losses having to be covered by the surviving parts of the industry. 11 amongst uninsured creditors, the position of bond holders will depend on whether they are issued from a ( pure ) holding company, in which case they have a structurally subordinated claim on the underlying business assets, or by operating companies that also have lots of other unsecured creditors. the exposure to loss of bonds issued by operating companies are, therefore, affected by whether or not they incorporate subordination clauses. for every bank group, all of that will be clear. the big issue, therefore, is about uninsured deposits. should they rank alongside senior unsecured bonds or should they be preferred? in the us, all deposits are preferred. there is now an active debate in the eu about whether or not it should introduce depositor preference and, if so, whether that should be for all or only some uninsured deposits