, official oversight, and market incentives ” ( lindgren, 1996 ). to this, i would add, “ robust financial infrastructure ”. the first line of protection against bank failure must be internal management ’ s own risk controls. the growing complexity and variety of banking business suggests that neither the authorities nor informed customers can prevent internal management from making mistakes if internal controls do not work. the best defense against mistakes and fraud are proper internal governance, or checks and balances. internal dual controls, together with both internal and external auditors, plus a proper disclosure policy would give the best incentives for internal management to perform according to proper rules of behaviour. public disclosure rather than private channels of information would be cheaper and reduce unwarranted expectations of what a regulator or supervisor can actually achieve. however, it is difficult, if not impossible, to guarantee full disclosure. it is doubtful whether free markets work well enough in conditions where information is partial and asymmetrically distributed and externalities exist. thus, it is not really possible for the authorities to shift entirely to reliance on disclosure and to abandon their specialised supervisory function. increasingly, therefore, the public oversight function is one of monitoring and surveillance, to ensure that systemic risks are not incurred at excessive public costs. when best practices and market standards are applied, any behaviour by regulatees that deviate from the norm would be subject to public scrutiny. there is therefore greater pressure for establishing international norms of performance, such as capital adequacy standards and risk management tools. the basle committee has recently established “ core principles ” to guide the regulation of banks. the application of certain regulatory tools, such as required capital ratios, exposure limits, constraints on self - dealing and camel ratings are designed to ensure that market participants comply with minimal standards of capital and risk exposures. it should be emphasised that effective regulation requires proper compliance and enforcement. this embodies the idea of “ bark versus bite ”. teeth must also include sound exit policies - non - exit implies no enforcement, which is the case of state - owned enterprises in the mainland of china. however, increasingly it is recognized that such rules should be kept simple and broad - brushed, in order to allow a rule - based environment to function. too many rules impose too heavy a regulatory cost, with redundant or excessive information burdens. however, given very rapidly changing market conditions, some degree of discretion can be more practical than rigid rules. on the other hand, excessive discretion can lead to

systematic forbearance ( time inconsistency ) that undermine rules and could even be subject to corruption and abuse. therefore, the time inconsistency problem can be solved by authorities pre - committing themselves to a sequence of automatic, graduated responses, giving the market time to adjust to rule changes or rule application. however, it must be true that the incentive or pay - off structure is one that must not be overlooked. one of the main reasons why agents do not abide by established control procedures is because it is not in their own perceived interest to do so ( goodhart, 1996 ). the best way to control risks is the market incentive to do so. for the market to work, there must be adequate information transparency, and an adequate pay ( or penalty ) structure that causes the private sector or market to regulate itself. for example, excessive bonuses may have caused the barings management to overlook the risks assumed by leeson. low pay for internal auditors relative to dealers may prevent them from raising the alarm bell. internal audit committees of financial institutions should signify that they have considered the implications for the risk preferences of key personnel of their pay structures. it is now better recognized that a robust financial infrastructure is also a form of regulator on market participant behaviour. modern financial infrastructure, such as automated payment systems, impose on market participants certain minimum standards of performance, such as time compliance in payments. failure of one participant to perform would immediately expose the participant to market discipline. there is therefore peer pressure on market participants to comply with the standards demanded by international payment systems. costs of regulation regulation is not without costs. the us estimates that regulation costs the consumer roughly 7 % of gdp annually, both directly or indirectly. bank regulation can be likened to deposit insurance - the higher the regulation and safety, the higher the insurance premium. one theory suggests that banks can elect to be one of three categories : super - safe banks, safe or normal. super - safe banks are only allowed to hold super - safe assets, but in return have 100 % deposit insurance. normal banks are allowed to hold any asset, but depositors get no protection at all. but super - safe assets offer a lower yield than normal assets, so the safer the bank the lower the interest rate offered to the depositors. the cost of regulation lies not only in the cost of preventing bank failure, but also the opportunity costs of foregone innovation. excessive or outmoded regulation results in loss of international competitive