paul tucker : financial crisis and g20 financial regulatory reform – an overview remarks by mr paul tucker, deputy governor of the bank of england, at the financial stability board ( fsb ) and korean g20 presidential committee conference, seoul, 3 september 2010. * * * being a western financial official, one comes to asia with some humility in truth. this has been a financial crisis born and bred in the western world, but inflicted throughout the world. that makes it all the more important that korea and the other countries in asia and elsewhere in the emerging market world are involved in the reform efforts. the reforms are not simply going to be cooked up in the west where the problems were bred. in korea, you have to play a really important leadership role, especially in steering us through the next couple of months. much of the work towards the leaders summit is being handled in the financial stability board. and here is a very brief overview of what is going on in the fsb contribution to the g20 effort, under the following headings : 1 ) surveillance ; 2 ) bank capital and liquidity ; 3 ) too big to fail ; 4 ) capital markets ; 5 ) incentives ; and finally the regulatory perimeter. 1. surveillance of the system very obviously this was a crisis that was not spotted – in the most important sense of being prevented – ahead of time. people did issue warnings about developing leverage in the system and accumulating macroeconomic imbalances. but no one acted to make the financial system more resilient to those vulnerabilities. this was not just an intellectual failure, as is widely discussed and recognized now. it was also partly a failure of machinery. the fsb has been encouraging new machinery to survey and head off risks. the fsb itself has created a vulnerabilities group. it is probably the least prominent part of the financial stability board ’ s effort to date, but it could have enduring significance over the years and decades. it is paralleled in various regions. europe is setting up a systemic risk board, which will be supported by the ecb but involve all of the eu. the usa is setting up a systemic oversight council ; and in the uk, the government is establishing a macroprudential financial policy committee in the bank of england. maybe something is needed in asia, too. martin [ wolf ] talked about complacency ; for the machinery i have described to make any difference, people will have to stick to it year

by construction – to be in a liquidity trap. as is well known, the optimal policy within this class of models is for the central bank to commit to low interest rates for an extended period and to a temporary overshoot of the inflation target. exchange rate depreciations ( svensson 2001 ) and interest rate commitments ( krugman 1998, woodford 2003 ) are examples of policy recommendations stemming from this result. the crucial insight emphasised by these models is that expectations matter, and provide a mechanism through which policy makers can seek to influence activity at the zero bound. this is an important channel of monetary transmission and one i will return to. but the argument that monetary policy can work only through expectations management is not a robust result. it rests on very particular assumptions. in this class of models, financial markets are assumed to be complete and frictionless and the representative agent is able to arbitrage across all financial markets. as such, all non - aggregate risk in the economy can be hedged perfectly and asset prices depend only on state - contingent payoffs. under these assumptions, demand curves for financial assets are perfectly elastic. but in the real world it seems plausible that demand curves for assets, in addition to money, are downward sloping to some degree, in which case changes in their relative supplies can affect their relative prices. it is this which gives quantitative easing its traction. half a century ago tobin ( 1958 ), in pioneering work on portfolio allocation, recognised that a range of assets, in addition to money, are likely to be imperfect substitutes. but tobin did not articulate fully the frictions that could generate such imperfect substitutability. more recently, there has been rapid development in micro models of the source of financial frictions which can motivate imperfect substitutability. recent examples include brunnermeier and pedersen ( 2009 ) and vayanos and weill ( 2008 ). 1 these models help to explain when and why investors may face un - diversifiable risks when holding specific types of securities, such that they become imperfect substitutes for otherwise similar assets. in brunnermeier and pedersen ( 2009 ), for example, marketmakers face uncertainty over the in addition see duffie, garleanu and pedersen, ( 2007 ). timing of customers ’ trades. they are unable to hedge perfectly this liquidity risk because of borrowing constraints, so that less liquid securities are imperfect substitutes for more liquid ones. this liquidity risk leads