in the reported financial sector output data. if we assume that true labour and capital productivity in the financial services industry grew in line with that in the wider economy in the 10 years prior to the crisis, then, given the inputs of capital and labour over that period, the official estimate might have overstated uk financial sector value added by almost £30 billion up to 2007 – around half of the growth in the official measure. the impact of this adjustment on overall gdp is likely to be relatively small because much of the output of the financial sector is treated as intermediate inputs to other sectors in the economy. such an estimate is supported by the finding of my bank of england colleagues that the increase in rates of return on equity earned by banks were accounted for almost entirely by an increase in leverage, capital gains on assets in trading books and the reported profits on contracts that produced losses only after the crisis occurred. and it is consistent with the estimates calculated by colangelo and inklaar ( 2010 ) for the euro area. they found that around 40 % of measured financial sector value added probably captured compensation for bearing risk. 3. the theory of banking why are banks so risky? the starting point is that banks make heavy use of short - term debt. short - term debt holders can always run if they start to have doubts about an institution. equity holders and long - term debt holders cannot cut and run so easily. douglas diamond and philip dybvig showed nearly thirty years ago that this can create fragile institutions even in the absence of risk associated with the assets that a bank holds. all that is required is a cost to the liquidation of long - term assets and that banks serve customers on a first - come, first - served basis ( diamond and dybvig, 1983 ). nevertheless, there are benefits to this maturity transformation – funds can be pooled allowing a greater proportion to be directed to long - term illiquid investments, and less held back to meet individual needs for liquidity. and from diamond ’ s and dybvig ’ s insights, flows an intellectual foundation for many of the policy structures that we have today – especially deposit insurance and bagehot ’ s time - honoured key principle of central banks acting as lender of last resort in a crisis. if the only problem is one of illiquidity leading to fragility, then central banks can easily act to ward off problems. by demonstrating a willingness to step in to provide temporary liquidity support

sure they will lead us to the right solution, and i look forward to their findings. 8. conclusions there is no simple answer to the to important to fail nature of banks. maturity transformation brings economic benefits but it creates real economic costs. the problem is that the costs do not fall on those who enjoy the benefits. the damaging externalities created by excessive maturity transformation and risk - taking must be internalised. a market economy has proved to be the most reliable means for a society to expand its standard of living. but ever since the industrial revolution we have not cracked the problem of how to ensure a more stable banking system. we know that there will always be sharp and unpredictable movements in expectations, sentiment and hence valuations of financial assets. they represent our best guess as to what the future holds, and views about the future can change radically and unpredictably. it is a phenomenon that we must learn to live with. but changes in expectations can create havoc with the banking system because it relies so heavily on transforming short - term debt into long - term risky assets. for a society to base its financial system on alchemy is a poor advertisement for its rationality. change is, i believe, inevitable. the question is only whether we can think our way through to a better outcome before the next generation is damaged by a future and bigger crisis. this crisis has already left a legacy of debt to the next generation. we must not leave them the legacy of a fragile banking system too. i have explained the principles on which a successful reform of the system should rest. it is a program that will take many years, if not decades. but, as bagehot concluded in lombard street, “ i have written in vain if i require to say now that the problem is delicate, that the solution is varying and difficult, and that the result is inestimable to us all. ” references admati, a. r., demarzo, p. m., hellwig, m. f., and pfleiderer, p ( 2010 ), “ fallacies, irrelevant facts, and myths in the discussion of capital regulation : why bank equity is not expensiv ” stanford business school, mimeo. arrow, k. j. ( 1951 ), “ an extension of the basic theorems of classical welfare economics ”, in proceedings of the second berkeley symposium on mathematical statistics and probability, ed. j. neyman, berkeley : university of