downswing, the intensity of deleveraging, liquidity hoarding and asset fire sales is proportional to the size of an institution ’ s balance sheet, as the squam lake report notes, but also to its interconnectedness and opacity. against this background, regulators are working to devise measures of systemic importance based on a combination of factors such as size, substitutability and interconnectedness, which could be drawn on to calibrate additional prudential requirements, for instance a surcharge. turning to the core of prudential regulation, in december 2009, the basel committee of banking supervision ( bcbs ), under the aegis of the g20, proposed a major overhaul 1 of the micro - prudential framework. there is a consensus that in the years prior to the crisis financial institutions were operating with too little capital, with excessive leverage and with insufficient recognition of the risks undertaken – including liquidity risk. the basel committee ’ s proposals envisage : raising the quality and quantity of capital 2, strengthening risk coverage 3, and introducing a non - risk - based leverage ratio 4 as well as a regime of countercyclical capital buffers. importantly, the new rules will comprise a novel, harmonised treatment for liquidity risk. rather than imposing capital requirements based on the liquidity of assets, the committee has opted for specific quantitative provisions ( outright liquidity ratios ) for directly promoting stronger liquidity buffers. in particular, banks will be required to hold sufficient high - quality liquid assets to withstand episodes of financial stress as well as to shift towards more stable sources of funds on the liability side. a substantive advantage of the liquidity framework proposed by the basel committee is its ability to improve the management of liquidity risk, which is inherently a cash flow risk and cannot be fully addressed via liquidity - based capital requirements only. the chosen option directly gears both the assets and liability mix towards, respectively, higher liquidity and more structural ( longer - term ) composition, also providing observable and verifiable metrics for the purposes of rigorous monitoring. by doing so, it explicitly promotes prudent liquidity risk management, thus minimising the likelihood of unexpected liquidity shortages, which may be covered only at prohibitively high cost at times of distress. agreement has been reached at g20 level that the new standards will be phased in as financial conditions improve and the economic recovery firms up, with implementation envis

##equacy and liquidity requirements, is in the making. it ’ s needed, but it ’ s not enough. the supervisory orientation has to shift from a light - touch approach to one that is more proactive, forward - looking and at times necessarily intrusive, as an indispensable complement to the rules. supervisors need to look more closely at the business and strategic risks of systemic institutions, gaining full knowledge of the strategies pursued and the sources of excess returns. supervisors should also be able to gain access to all the parts of the group, regardless of the legal status of the supervised entity. furthermore, regulators and supervisors have to be alert to the fact that financial innovation, by adding layers of leverage, complexity and opacity, can transform the risk profile of even traditionally safe assets. at the same time, the regulatory net must be extended to the whole range of leveraged institutions which can trigger systemic risk, including the shadow banking system and other firms that pose potential systemic risks such as hedge funds. any changes in the regulatory framework must be carefully scrutinised so as to minimise the risks of regulatory arbitrage and not provide incentives to transfer certain types of systemically relevant risk beyond the perimeter of the regulated sector. higher prudential requirements, whether inside or outside the banking system, should be imposed on riskier activities, regardless of their location. the following developments are in line with the bcbs “ principles for enhancing corporate governance ”, issued in march 2010. furthermore, changes to the prevailing practices in executive compensation are needed. an effective – and stringent – executive compensation framework should be designed to ensure that managers, who play a key role in defining their institutions ’ risk strategies, are not rewarded for artificial excess returns, such as those stemming from positions whose risks have not yet materialised. in addition, enhanced supervisory cooperation, especially between major financial centres, as well as an extension of the coverage of the international framework, to all the financial services institutions, notwithstanding their legal status, is essential.