for years on an ever - expanding real estate sector fuelled by increasing borrowing. looking at specific market segments, there are plenty of examples showing the excesses of the financial sector, and also illustrating the importance that the “ shadow ” banking system has played in this crisis. for example, the growing use of securitisation by banks led to a distinctly lax screening of loans. 8 as a result, mortgage credit growth became disconnected from both relative and absolute income growth in the sub - prime market. 9 the crisis itself started not as a traditional bank run on deposits, but as a securitized - banking run driven by the withdrawal of repurchases ( “ repo ” ) agreements from the balance sheets of investment banks, which had been funding roughly half of their assets through repo markets. 10 during financial bubbles, the search for yield intensifies, risk - taking is everywhere, and leverage in the system may increase at unsustainable rates. the exponentially rising volume of financial assets and transactions, especially by highly leveraged and interconnected institutions, can increase financial instability. shocks to the system can lead to fire sales and asset price decreases, resulting in liquidity spirals and widespread bankruptcies. 11 on the “ real ” side, the aftermath of the busts which follow unsustainable booms are frequently associated with falling housing prices, collapsing equity prices, and lasting declines in output and employment. under certain circumstances, the negative impact on potential output could be long - lasting rather than transitory ( see figure 1 ). in addition, financial crises like the recent one tend to worsen the fiscal position of many countries. government debt explodes in the wake of banking crises, fuelled not so much by the cost of recapitalising the banking systems but by collapsing tax revenue. 12 as can be seen from this rather sketchy argumentation, the damage caused by “ oversized ” financial markets can be quite substantial. but even if we are aware that there are limits to the “ optimal ” size of financial markets, we still run into practical problems if we try to establish the right “ threshold ”, and research in this field has been very limited. just a handful of researchers in recent years have studied the non - linearities in the relationship between the size of financial markets and economic growth using cross - country evidence 13, and they have concluded that at “ too high ” levels of finance, the effect of finance on growth substantially weakens. but this line of

banking system. traditionally, capital requirements tend to alleviate moral hazard problems in the banking sector in the presence of deposit insurance, and allow banks to form a “ cushion ” against losses for depositors. in particular, they protect depositors both by preventing bank managers from embarking on risky projects by making sure that banks have a sufficient equity at stake, and by allowing regulators to close and recapitalise banks before equity value falls to zero and debt holders start making losses. given the trade - off between financial stability and growth, what are the correct capital requirements? and would “ getting them wrong ” endanger the economy? comparisons between countries have shown that bank systems are capable of performing their intermediation role with very different levels of capital. in both the uk and the us, for example, banks in the past had much higher capital ratios and much lower leverage, and still managed to sustain growing market economies. of course, capital requirements that are too high will impose a cost on the banking system as bank capital is more expensive than senior debt or deposits. but even if “ too high ” capital requirements result in less lending, this is not necessarily detrimental to the whole economy. as i mentioned above, the expansion of sub - prime lending clearly imposed a negative externality on the whole economy, and so in hindsight regulatory measures that would have prevented such credit expansion could in fact have been beneficial. to summarise, capital requirements, and leverage ratios serve well to illustrate the trade - off between stability and growth i mentioned at the beginning. the examples i provided earlier show that the costs incurred when an “ oversized ” financial system unwinds are very large and outweigh any pre - crisis gains. therefore, prudent regulatory action to restore the balance between stability and growth is perfectly justified. 5. conclusions financial markets are crucial players in a dynamic modern economy, channelling resources from savers to borrowers and allocating them to productive investment opportunities. at the same time, our experience in the past decade has highlighted the dangers of allowing financial sectors to become “ too large ”. in doing so, negative developments like the hunt for rents, the propensity to herd and create bubbles, the misalignment of incentives, and the proliferation of complex innovative financial instruments may outweigh the benefits of finance. there are plenty of examples pointing to the fact that before 2007 the financial sector may indeed have grown “ too large ”, mainly due to developments outside of the traditional banking system.