, this treatment has no longer seemed justified, as it has become apparent that government bonds do carry some solvency risk. it would therefore be appropriate to change the rules in the medium term. we believe that government bonds, just like other loans, should be backed with sufficient capital to reflect the risks that they carry. at the same time, a ceiling could be imposed on lending to any one government, just as lending to other borrowers is subject to a limit of this kind. these two measures combined would shield banks from the impact of public finance problems. by adjusting the rules, governments can help to make banks, and hence the financial system, more stable. however, rules are only effective in the areas where they apply. and there is one area of the financial system which is not yet truly regulated : the shadow banking system. i have to confess that i don ’ t really like the term “ shadow banking ”, as it strikes me as slightly unfair. it makes the industry sound rather shady, or even criminal. and that certainly isn ’ t the case. the shadow banking system contains entities which, like banks, perform credit intermediation. the difference is that these entities – such as us - style money market funds – don ’ t belong to the regulated banking sector. shadow banks are not bound by the normal “ rules of play ”. in terms of financial stability, the crux of the matter is that these entities can cause similar risks to banks but are not subject to bank regulation. and the shadow banking system can certainly generate systemic risks which pose a threat to the entire financial system. much the same applies to insurance companies. although they aren ’ t a direct component of the shadow banking system, they can also be a source of systemic risk. all of this makes it appropriate to extend the reach of regulation. 4. conclusion in conclusion, i would like to reiterate the three main points of my speech. • first, we need to redraw the boundaries between the state and the market by tackling and solving the problem of systemically important banks. • second, the state needs to amend bank regulation – not least by requiring banks to hold capital against government bonds. bis central bankers ’ speeches • and third, the state must extend the reach of regulation. the shadow banking system and insurance companies also warrant our attention – albeit for very different reasons. these three aspects are crucial to ensuring financial stability, but they will not be sufficient on their own. we need to be clear

this, i believe that two elements will be especially important in making banks more stable : capital and liquidity. deficits in both of these things were factors which contributed significantly to the financial crisis. the state can bring in regulation to address these deficits, and has done so very successfully. amending the capital and liquidity requirements was therefore very high on the international reform agenda right from the start. and the new basel iii regime significantly raises capital requirements for banks. in future, banks will need to hold more – and better - quality – capital, and the requirements for systemically important financial institutions are stricter still. in addition, basel iii has introduced the very first international liquidity standard. these rules will play a crucial role in safeguarding financial stability. however, there is still a weak link in the capital rules – as the euro - area crisis has clearly shown. the need to bail out systemically important banks with taxpayers ’ money puts pressure on government budgets. that was one of the focal points of the first part of my speech here today, and i mentioned ireland as a striking example. yet problems can also flow in the bis central bankers ’ speeches opposite direction : shaky public finances can cause difficulties for banks. greece is a case in point. this kind of contagion is mainly caused by government bonds held on bank balance sheets. and many banks have large holdings of domestic government bonds, especially in the euro area. take italy and spain, for example. current figures show that italian banks hold more than 10 % of all bonds issued by the italian public sector, and that spanish banks hold almost 9 % of spanish public bonds. essentially, this is a vicious circle : a country ’ s public finance problems spill over to domestic banks, while banks ’ woes place a strain on government budgets in the country where they are based. to better protect public finances, we need bank resolution mechanisms and the option of a “ bail - in ”. but how can we shield banks most effectively from the impact of public finance problems? these risks stem from government bonds held on bank balance sheets. and that is precisely where the problem needs to be tackled. bank regulation treats government bonds comparatively generously. usually, the higher the risk attached to a loan, the more capital a bank must hold against it. yet this does not apply to lending to governments – and thus to government bonds. bank regulation classifies them universally as risk - free. yet since the onset of the sovereign debt crisis, if not before