jose de gregorio : what does society expect from the financial sector? panel discussion remarks by mr jose de gregorio, universidad de chile and former governor of the central bank of chile following the per jacobsson lecture by dr yv reddy, 24 june 2012, basel, switzerland. * * * i would like to thank the bis for the invitation to participate in this panel, which makes us look at financial markets from a new perspective. as policymakers, we are used to talking about how the financial system must operate in order to fulfill its goals without threatening financial stability or imposing costs at the aggregate level. in recent years, the discussion has focused on how to avoid excessive procyclicality, contagion, moral hazard, and other important policy concerns. as economists, we have been trying to explain the misbehavior of financial systems, and we are still searching for answers. although we may have some ideas, the policy implications are not straightforward, but the answers cannot wait. policy design needs answers as soon as possible, and delays may cause well intentioned policies to be poorly implemented. but what society really demands from financial systems is quite difficult to define. society is a collection of actors, with different interests and different needs. people want access to the financial system at fair conditions. therefore it is useful to think of society as everyone who is not related directly to the financial industry or policymaking. starting from here, we can say that society is demanding safer and fairer financial systems. the view that financial markets were big casinos, where the betting was done with other people ’ s money and gamblers walked away unpunished, is quite common around the world. public opinion has been dominated by that sentiment, which has also affected policymaking. on financial development let me start by stressing that financial intermediation is good, and with the backlash from the crisis it should be repeated that a well functioning financial system is key to prosperity. it promotes economic growth by channeling investment funds from savers to borrowers ( levine, 2006 ). it is central to promoting entrepreneurship and to facilitating investment, including human capital accumulation. it provides financing to households in order to smooth consumption, and provides insurance. it provides safe and cheap means of payment. the difficulties faced by households and firms in many emerging market economies due to underdeveloped financial institutions and markets should be a clear reminder of this positive role. but financial depth may also be a source of great problems. as in

may end up generating exclusion rather than lower financial costs for households, who may end up paying much higher interest rates in informal credit markets. this is not the place to analyze all the causes and culprits of the crisis, but it is worth discussing certain aspects that are frequently singled out by the general public. first and foremost, the crisis was caused by the irresponsible behavior of the financial industry. the structure of incentives was unsuitable. it led to excessive risk - taking without proper risk management. compensation was heavily biased towards deal - making, regardless of the quality of the deals. commissions and fees were a very important component of the compensation scheme. in the end, all that mattered was granting credit indiscriminately, maximizing packaging and selling securities, etc. this was at the foundation of the originate - and - distribute model of financial services, and served to increase leverage to unsustainable levels. we know that linking compensation to productivity is efficient, but the devil is in the details. second, the regulation - making process, as very well discussed in dr. reddy ’ s lecture, was also distorted by comprehensive capture by the financial industry. as he explains, this was not only capture of the regulators, but also capture of public policy relating to the financial system. with a little bit of moral hazard, which is exacerbated by regulatory and policy capture, the result was the creation of a very vulnerable financial system. finally, there was indifference in policy circles. none of us saw it coming, at least not with the intensity with which it arrived, which still persists. indeed, it was difficult for those of us from emerging markets to think that this could happen in the advanced world. whenever we had raised a concern we had been told that “ these are developed countries, ” as an argument that “ this time is different ”. there were, of course, calls for prudence, in particular from this institution, but we never thought that the consequences would be so dramatic. markets should provide enough discipline to balance risk and return, but that was not exactly the case. the market functioned poorly. in addition, we had a sense of security given the “ decoupling ” that took place in the 2000s, in part due to good macroeconomic management, and which became a recoupling by mid - 2008 ( dooley and hutchison, 2009 ; korinek et al., 2010 ). it is easy to put the blame on