( 2007 ). matsuyama ( 2007 ). rajan ( 2006 ). adequate when managers take on little risk. however, when these returns are low, managers need to take on higher levels of risk to achieve sufficient compensation. moreover, in times of low interest rates, the low cost of funds encourages managers to increase leverage, further increasing their exposure to risk. in short, what we have learned in the past few years is that by promoting interest rates that are too low, monetary policy may create incentives that put at risk financial stability. the second consideration is that it is very difficult for central banks to take financial stability issues into consideration in the conduct of their monetary policy. a fundamental problem is that the economics profession is still far from having a good understanding of asset price bubbles. indeed, we still do not know whether they exist at all! 10 one can certainly argue that they are likely to occur in market economies. it takes, at most, a couple of small, realistic modifications to the standard models of intertemporal optimisation, such as the introduction of a subset of agents with a finite horizon, for bubbles to be generated. 11 however, there is a great difference between suspecting that bubbles exist and identifying them in real time. running policy on something that is essentially unobservable is, for sure, not a recipe for success. neither do we have a good grasp of the sustainability of the balance sheets of households, firms and financial institutions in the same way as we have for the sustainability of public finances. this is probably a relict of a time in which financial markets were severely repressed and only the government was “ free ” to borrow without limits and, by so doing, to push its intertemporal budget constraint to the limits of sustainability. but now we live in a completely different financial order, one in which borrowing is open practically to anybody – at least in developed countries – with assets being created with a rating similar to that of the best public borrower. this could also push private agents ’ intertemporal budget constraints to the limits of sustainability and, in a sense, put financial stability ( as defined a little earlier ) constantly at risk. if we knew, for example, that net household debt above, say, 100 % of household income was not sustainable, then we would have a clear idea of its future consequences and the optimal policy response would flow naturally from this recognition. however, we are certainly not there yet. the third general

, capital for trading book exposures was distressingly inadequate. in response, the committee finalised last year a series of enhancements to the trading book rules. these higher capital requirements capture the credit risk of complex trading and derivative activities and require banks to calculate a stressed value - at - risk. the crisis also exposed weaknesses in banks ’ risk management and measurement of securitisation and off - balance - sheet exposures. this shortcoming resulted in large, unexpected losses. the committee ’ s july 2009 enhancements included new rules to strengthen the treatment for certain securitisations in pillar 1 by introducing higher risk weights for resecuritisation exposures. counterparty credit risk is another key risk for which the regulatory capital improvement is needed. the december enhancements proposed by the committee are meant to strengthen the resilience of individual banking institutions and reduce the risk that shocks are transmitted from one institution to the next through the derivatives and financing channel. raising the quality of the capital base the committee ’ s efforts to improve risk coverage are a crucial element of the capital adequacy equation but this is only half the story. the other half relates to the quality of the capital base backing banks ’ risk exposures. the committee has proposed a series of measures that would overhaul the definition of capital. this is the second objective of our reform programme and it is set out broadly along two lines. first, the level and the share of the highest quality capital in tier 1, namely, common equity and retained earnings, will rise substantially. during the crisis, losses came directly out of retained earnings but because of other forms of financial instruments in the capital base, some banks maintained deceptively high tier 1 capital ratios. moreover, in the case of many banks, non - common tier 1 capital instruments ultimately had to be converted into common equity before confidence was restored. second, and just as important, our proposal introduces a rigorous set of deductions and exclusions from common equity to arrive at a more transparent, meaningful definition of capital and to restore the credibility of the tier 1 capital base. leverage ratio as a backstop to the risk based requirement a third objective is the introduction of a leverage ratio to backstop the risk - based system. at the micro, firm - specific level, many firms were too aggressive in gaming the system. the risks that built up in the trading book with inadequate regulatory or economic capital were a case in point. many firms engaged in hedging strategies where the risk