vehicles in which they retained contractual and reputational liquidity exposures. these vehicles, like banks themselves, were funding longer - term assets with short - term liabilities, and, like banks, they were subject to a run when their lenders became concerned about the quality of the assets. some banks wound up using their own liquidity to support financing vehicles that were no longer able to fund themselves on anything like the same terms and conditions as before the market turmoil began. and as banks made good on the implicit or explicit liquidity insurance they sold, they found themselves with larger balance sheets and less - robust capital cushions than they anticipated. as the banks'capital and liquidity cushions unexpectedly eroded, they became quite cautious about extending credit, a dramatic change from the more complacent attitudes of previous years. concentration risk is another familiar risk that is appearing in a new form. banks have always had to worry about lending too much to one borrower, one industry, or one geographic region. but as smaller banks hold more of their balance sheet in types of loans that are difficult to securitize, concentration risks can develop. concentrations of commercial real estate exposures are currently quite high at some smaller banks. this has the potential to make the banking sector much more sensitive to a downturn in the commercial real estate market. the private sector needs to respond to protect their capital and liquidity, banks and other financial market participants are addressing the weaknesses revealed by market developments by becoming much more careful about the risks they are taking. this is a necessary process, but it has been a difficult one as well ; it is reducing the values of some assets and tightening credit cost and availability across a wide range of instruments and counterparties, despite considerable easing in the stance of monetary policy. it is this tightening that is accentuating the downside risks for the economy as a whole. and in some sectors, as lenders seek protection against perceived downside risks, it is probably going further than is necessary to foster financial stability in the long run. but we will end up with a safer, more robust financial system. for banks, a safer and more robust financial system will be characterized by improved risk management that incorporates the lessons from the recent turmoil. successful risk management looks comprehensively across business lines and is fully integrated into the decisionmaking of senior management. it identifies stresses and scenarios that might seem remote, but that could threaten safety and soundness. banks'own self - interest clearly provides a strong incentive to

some recent examples of the budgetary cost of systemic failures. it covers only recent episodes in oecd countries ; much higher figures could have been cited if the coverage had been extended to developing countries. ry systemic banking crises : cost of recapitalisation cost count eriod as % of gdp finlan d 8. 0 991 - 1993 norwa y 4. 0 987 - 1989 spain 16. 0 977 - 1985 swede n 6. 4 united states ( s & l ) 3. 2 984 - 1991 source : caprio and klingebiel, world bank, july 1996 the other reason for the recent emphasis on financial system stability is that economies appear to be more susceptible to instability as a result of the deregulated financial markets. australia ’ s experience in the late eighties points in this direction, but it is not an absolute rule. just as japan has shown that type ii episodes can occur without a lot of foreign capital flows ( in fact, there were net outflows ), there are many african and latin american examples of it happening in a heavily regulated environment. the asian countries, including japan, which are now going through these difficulties could not be characterised as possessing highly deregulated financial sectors. the two asian countries which most closely approximate the deregulated model are hong kong and, to a lesser extent, singapore. to date, these countries have fared reasonably well. the link between deregulation of financial markets and instability is obviously more complicated than meets the eye. it would probably be better to say that the transition phase from regulation to deregulation is a dangerous period. this will be especially so if the transition is rapid, and if it is not accompanied by increased transparency and the enhancement of other policies directed at system stability. 3. problems and remedies in essence, therefore, a type ii economic crisis is one which is centred around a failure of the financial intermediation process. the centrepiece of it is an environment which leads to excessive competition by banks to lend, resulting in a severe reduction in credit standards. the following features are normally present : • lending to related parties ; • excessive concentration of lending to particular borrowers or areas, e. g. property ; • excessively high loan to valuation ratios ; • inadequate covenants to restrict the activities of borrowers ; • lending based on asset values, rather than capacity to service from income ; • failure to recognise and provide for deterioration in loan quality ; • lending