the sole source of intermediation. their breakdown induces a marked weakening in economic growth. a wider range of nonbank institutions, including viable debt and equity markets, can provide important safeguards of economic activity when the banking system fails. fifth, despite its importance for distributing savings to their most valued investment use, excessive short - term interbank funding, especially cross border, may turn out to be the achilles ’ heel of an international financial system that is subject to wide variations in financial confidence. this phenomenon, which is all too common in our domestic experience, may be particularly dangerous in an international setting. i shall return to this issue later. finally, an important contributor to past crises has been moral hazard, that is, a distortion of incentives that occurs when the party that determines the level of risk receives the gains from, but does not bear the full costs of, the risks taken. interest rate and currency risk - taking, excess leverage, weak financial systems, and interbank funding have all been encouraged by the existence of a safety net. the expectation that national monetary authorities or international financial institutions will come to the rescue of failing financial systems and unsound investments clearly has engendered a significant element of excessive risk - taking. the dividing line between public and private liabilities, too often, has become blurred. * * * given that the existence of safety nets generates moral hazard, and moral hazard distorts incentives, why do we continue to provide safety nets to support our financial systems? it is important to remember that, notwithstanding the possibility of excessive leverage, many of the benefits banks provide modern societies derive from their willingness to take risks and from their use of a relatively high degree of financial leverage. through leverage, in the form principally of taking deposits, banks perform a critical role in the financial intermediation process ; they provide savers with additional investment choices and borrowers with a greater range of sources of credit, thereby facilitating a more sophisticated allocation of resources that appears to contribute importantly to greater economic growth. indeed, it has been the evident value of intermediation and leverage that has shaped the development of our financial systems from the earliest times - - certainly since renaissance goldsmiths discovered that lending out deposited gold was both feasible and profitable. in addition, central bank provision of a mechanism for converting highly illiquid portfolios into liquid ones, in extraordinary circumstances, has led to a greater degree of leverage in banking than market forces alone would support. traditionally this has been accomplished by making discount

support members of an associated group of companies. experienced bank supervision cannot fully substitute for poor lending procedures, but presumably it could encourage better practice. apparently even that has been lacking in many economies. and training personnel and developing adequate supervisory systems will take time. i pointed earlier to cross - border interbank funding as potentially the achilles ’ heel of the international financial system. creditor banks expect claims on banks, especially banks in emerging economies, to be protected by a safety net and, consequently, consider them to be essentially sovereign claims. unless those expectations are substantially altered - - as when banks actually incur significant losses - - governments can be faced with the choice either of validating those expectations or of risking serious disruption to payments systems and to financial markets in general. arguably expectations of safety net support have increased the level of cross - border interbank lending from that which would be supported by unsubsidized markets themselves. this would suggest resource misallocation. accordingly, it might be useful to consider ways in which some added discipline could be imposed on the interbank market. such discipline, in principle, could be imposed on either debtor or creditor banks. for example, capital requirements could be raised on borrowing banks by making the required level of capital dependent not just on the nature of the banks ’ assets but also on the nature of their funding. an increase in required capital can be thought of as providing a larger cushion for the sovereign guarantor in the event of a bank ’ s failure. that is, it would shift more of the burden of the failure onto the private sector. alternatively, the issue of moral hazard in interbank markets could be addressed by charging banks for the existence of the sovereign guarantee, particularly in more vulnerable countries where that guarantee is more likely to be called upon and whose cost might deter some aberrant borrowing. for example, sovereigns could charge an explicit premium, or could impose reserve requirements, earning low or even zero interest rates, on interbank liabilities. increasing the capital charge on lending banks, instead of on borrowing banks, might also be effective. under the basle capital accord, short - term claims on banks from any country carry only a twenty percent risk weight. the higher cost to the lending banks associated with a higher risk weight would presumably be passed on to the borrowing banks. borrowing banks, at the margin, might reduce their total borrowing or shift their borrowing to nonbank sources of funds, perhaps with the shift facilitated by the lending banks, who