for them not to be needed. there is trust between the borrower and the bank. the bank is trusting that the borrower will repay the loan. the bank can do a lot of due diligence on the borrower to be reasonably confident that the lender will repay. but ultimately there will be some trust involved. the bank needs to trust that the borrower has provided accurate information and will act in good faith. there will, however, always be a gap between what the bank can learn through its due diligence and what it needs to be completely confident the loan will be repaid in full. because the process of financial intermediation often has a number of links in the chain, there also needs to be trust between financial institutions. many financial transactions don ’ t just involve one bank lending out its deposits to the end - borrower. often the funds are on - lent to one financial institution after another, before ultimately finding its way to the end - borrower. so trust needs to be present at every stage in the chain. one breakdown in this chain of trust between counterparties can throw a spanner in the works of the whole process. ultimately there is only so much due diligence that can be done. risk is always present in the financial system. information asymmetries will always be present between the two parties in a financial transaction. transparency can reduce but not eliminate the risk from these asymmetries. bis central bankers ’ speeches finally, there has historically been trust between regulators and financial institutions. ( i am not sure there is all that much of this trust at the moment, as i will discuss later. ) “ trust me, i know what i ’ m doing ”, was the banker ’ s exhortation for the light touch approach to regulation that was pervasive prior to the crisis in many countries, most obviously the uk. the argument was that banks should be broadly left to their own devices, with the discipline provided by the market deemed sufficient to keep them on track. the breakdown of trust having described the critical role that trust plays in the process of financial intermediation, i will now describe how trust has broken down over the course of the financial crisis. the period leading up to the financial crisis saw what might be labelled, in the context of my talk today, the development of lazy trust. things were generally going along fine, so my due diligence was that i will take you, the lender, at

on risk and uncertainty ”, address to risk australia conference, sydney, 31 august. bis central bankers ’ speeches without any security ( unsecured lending ). in plain english, this means that banks would only lend to another bank if the borrowing bank would provide something like a government security or a portfolio of mortgages as collateral to the loan. then even if collateral was provided, the length of time they were willing to provide the loan for shortened, because of a concern that the borrower would not survive long enough to repay. this placed some financial institutions in significant financial difficulty. concerns mounted as to whether some institutions would be able to fund themselves at all. as a result of this, the european central bank ( ecb ) announced that it would provide as much funds as banks in europe required through three year loans. so the european central bank has become the intermediary of last resort for the european banking system because the banks do not trust each other. more recently, as the lack of trust of some of the governments of europe has intensified, the ecb has had, in effect, indicated its willingness to act as intermediary of last resort to these governments too. one of the main reasons the ecb has decided to do this is because of the lack of trust in the longevity of the euro. investors are concerned about the possibility of redenomination risk : the possibility they are left holding an asset whose value is markedly decreased, when a country leaves the euro area and re - introduces its own currency. as a result of this mistrust, we are witnessing a balkanisation of the financial system in europe. investors in one european country don ’ t trust banks or governments in other countries. they pull back from financing across borders, preferring instead to invest their money close to home. this almost certainly is not an optimal allocation of funds to their most productive use. on top of this dangerous state of affairs in europe, and amplifying the diminution of trust in the financial sector, recent controversies in the banking sector have hardly provided any justification for the public regaining trust in the banking system. to the extent that trust was slowly being restored in some parts of the banking system over the past few years, it was shattered by the recent revelations surrounding the libor scandal, allegations of money laundering and the like. the restoration of trust so all in all, the state of the financial system in many parts of the world is not in good shape. so what is to be done