basis. the financial crisis exposed significant vulnerabilities in the financial system. without revisiting all the causes and consequences of the credit boom and bust that led to a boom and bust in the u. s. housing market, the bottom line is that our regulatory system failed in two important dimensions. first, a significant number of large, internationally active financial firms reached the brink of failure. second, the financial system was not very resilient when these firms got into difficulty. instead, the threat of failure propagated further shocks that reverberated throughout the global financial system. these two shortcomings reflect many factors including inadequate capital and liquidity buffers, poor incentives to correctly measure, price and manage risks ex ante, the opacity of firm balance sheet and counterparty exposures, and the manner in which large financial firms were interconnected within the financial system. in the end, there was too much leverage in which large amounts of highly illiquid, long - term assets were financed by short - term liabilities. the fact that a large amount of the wholesale funding used to finance these assets was provided by leveraged financial intermediaries to other financial intermediaries increased the bis central bankers ’ speeches system ’ s vulnerability to adverse shocks. as it turned out, the amount and quality of capital was grossly inadequate relative to the quality of the assets and off - balance - sheet exposures of many of the major global banking institutions. moreover, many institutions had inadequate liquidity buffers. the lack of liquidity forced the fire sale of assets, which depressed prices and increased the pressure on capital. when troubled institutions did fail, this exacerbated the pressure on the remaining institutions. aggravated by the lack of transparency about their counterparty exposures and the contingent liabilities they faced, the problems of a single institution quickly became the problems of many. this was fueled in part by concern that the counterparty claims on failed institutions would be frozen and unable to be realized quickly. not only did some core firms have inadequate capital and liquidity, they also faced conflicting incentives as to how to manage their capital resources. for example, many firms that came under stress were slow to cut their dividends or to raise new capital because of fears that such actions would signal their underlying weakness. obviously, the failure to conserve capital made these institutions weaker rather than stronger. the crisis also underscored severe deficiencies in the international dimension of the regulatory environment. financial institutions

rules for banks, there is a danger that the risks migrate from banks into the non - bank sector. and here i want to touch upon another pre - crisis illusion – the liquidity illusion. reforming the capital framework the market in 2008 and 2009 clearly did not believe either the numbers for bank capital or for bank assets. capital was not just pure equity. tier 1 capital also included so - called “ hybrid ” capital instruments – debt that was supposed to convert to equity to absorb losses. however, the ability of these instruments to absorb losses proved to be illusory. moreover equity itself was distorted by factors such as the inclusion of deferred tax assets – tax credits that could only be realised when a profit was made and so of no use in a crisis. and banks were slow to recognise losses – leading capital ratios to be overstated. and, as to banks ’ assets, the major banks were, by 2008, using their own models to assess the riskiness of much of their portfolios for regulatory capital purposes. from their origin in the late 1980s, the international capital adequacy standards – the basel standards – had bis central bankers ’ speeches focussed on risk adjusted capital. this was based on the sensible principle that the level of a bank ’ s capital should reflect the riskiness of its assets. as the basel standards developed, banks were increasingly, first for the trading book in 1996 and later, through the move to basel 2 in 2008, for the banking book as well, able to use their own modelling to assess the riskiness of their assets. again, there was logic in this. it replicated for regulatory purposes the way the banks themselves managed risks. however, as the banking system became more and more levered, as banks ’ balance sheets grew and grew, the measured riskiness of banks ’ assets – measured in large part by their own models – declined. in the ten years to 2007, the size of banks ’ balance sheets in the uk had doubled relative to the size of the economy. but over the same 10 years, the average risk - weight for the assets of the major uk banks had fallen to almost 40 % – down by around a fifth from its level a decade earlier. as a result, the increase in banks ’ balance sheets was not matched by anything like a commensurate increase in capital. when the crisis struck, not only did a significant portion of the assets turn out to be far riskier than estimated. market confidence in the risk