limit systemic fallout. with the shadow banking system, we have to ensure that tighter regulatory rules do not provide incentives for financial institutions to shift their activities to unregulated areas. oversight of the shadow banking sector needs to be improved. the fsb has already done valuable work – supported by the ecb – on shadow banking. in this context, the ecb is providing the financial stability board ( fsb ) with flow of funds data on the composition of the financial sector concerning the euro area. the concrete challenges lie in the establishment of a suitable definition of shadow banking and outlining possible regulatory options to address the risks posed by this sector. given the background of the crisis, regulatory effort on financial institutions has focused on banking, but there is important work underway also for other financial institutions, such as the further specification of the capital adequacy regime for insurance companies ( “ solvency ii ” ). ii. market regulation let me turn to the second building block, namely regulation of financial markets. this area is as challenging and as complex as banking. the main observation we have to draw from the crisis is that the risks in market returns were not mainly exogenous, coming from the stochastic variation in the real economy. they came from financial risk itself. the financial structures that we thought were in place to assess, absorb and neutralise risk were either dysfunctional or worked to magnify volatility. key factors in creating this risk were opaque financial structures, particularly vulnerability to contagion and domino effects, and pro - cyclicality in financial markets. the lack of transparency in many financial instruments meant that some market players could exploit – for their own, private benefit – information that was not generally available. bis central bankers ’ speeches pro - cyclicality acts as a formidable accelerator of financial trends. two important factors that drive such amplification are distorted incentives and herd behaviour. the role of distortions in economic incentives is probably better known as it had traditionally been widely appreciated even within neo - classical modelling. by comparison, herd behaviour as a driver of pro - cyclical patterns in financial markets still needs a thorough explanation. it is difficult to rationalise herd behaviour. there are two possible explanations. one is the significance of a market player ’ s evaluation of his or her performance relative to the rest of the market. this is reminiscent of keynes ’ famous beauty contest analogy. to be successful in this environment, individual participants do not form their own opinions, but follow the general mood

##l action. the birth date of macroprudential oversight in europe will probably be identified as the start of this year but it was originally conceived in 2009 through the work of jacques de larosiere and his high - level group, which included my friend otmar issing. eighteen months from policy design to institutional establishment is a remarkable achievement. it was made possible by thorough groundwork as well as excellent transposition by the commission and very rapid decisions by the european parliament and the european council. i feel very honoured to chair this new body, the esrb. let me focus on each of these three building blocks in turn, starting with banking. bis central bankers ’ speeches i. banking regulation and basel iii basel iii, which constitutes the cornerstone of regulatory reform for the banking sector, provides for higher minimum capital requirements, better risk capture, a stricter definition of eligible capital elements with a particular focus on common shares and more transparency. the revised regulatory framework allows appropriate transition periods for financial institutions to adjust to the new standards, thereby ensuring a smooth phasing - in of the new regulatory requirements without compromising the nascent economic recovery. by 1 january 2015, the minimum capital requirements for common equity tier 1 and total tier 1 capital will gradually be raised up to a level of 4. 5 % and 6. 0 %, respectively. this gradual phasing - in of minimum requirements will be complemented by an appropriate observation period for the non - risk - based leverage ratio and the liquidity standards. the esrb, together with the eba, will play an important role in policy setting and implementation, with the former contributing to ensuring consistent implementation of the policy framework throughout the eu. we are just beginning that process. in addition to the necessary transposition into national or european law of the basel iii rules, there are two issues that still need to be addressed : systemically important financial institutions ; and capturing the so - called shadow banking system within the regulatory framework. work is in progress on systemically important financial institutions, in particular in the financial stability board. the main objectives are to reduce the probability of failure of such institutions and, in case a failure occurs, to reduce the impact on the financial system. in september 2010, the governors and heads of supervision agreed that systemically important financial institutions should have additional loss absorbing capacity. work is currently underway on how to define institutions that are systemically important, and how to determine the capital surcharges, contingent capital and other elements to