for international settlements ( bis ). 1 the report noted that financial institutions are likely to respond to the increased calls for collateral by changing the way they do business. some change is clearly desirable, given that a number of risks were previously underpriced. but if past experience is any guide, as prices change and the demand for collateral increases, financial institutions will seek to manage their collateral more efficiently and this is likely to increase interconnections in the financial system. the report also noted that the greater collateralisation is likely to increase the procyclicality of the financial system and to increase uncertainty about the strength of the claim that unsecured creditors have over the assets of a financial institution. so there are clearly tensions. reducing counterparty risk is an appropriate objective. but the bis report suggests that the side effects of doing so could run counter to achieving other high - level objectives, including reducing interconnectedness, reducing procyclicality and reducing uncertainty. the challenge is getting the balance right so that fixing one problem does not create another one. a second example of where tension between objectives is evident is in the effort to increase the stability of banks ’ funding. in this context, it has become common to think of deposits as “ good and stable ” and wholesale funding as “ bad and unstable ”. signs of this thinking are evident in australia, as they are in many other countries. many financial institutions have had an explicit objective of increasing the share of their liabilities that are accounted for by deposits. consequently, they have been prepared to pay large premiums for liabilities that are called deposits relative to wholesale funding liabilities of similar maturity. this has pushed up banks ’ overall funding costs and led to increased spreads between lending rates and wholesale rates. it is difficult to argue with the idea that this shift towards deposits is helpful for overall financial stability. while there can be a deposit run on an individual bank, a deposit run on the system as a whole is very unlikely, as deposits tend to get recycled from one bank to another. in comparison, it is easier to think of scenarios in which disruptions to foreign wholesale funding cause system - wide stress. cgfs ( committee on the global financial system ) ( 2013 ), “ asset encumbrance, financial reform and the demand for collateral assets ”, cgfs papers no 49, may. available at < http : / / www. bis. org / publ / cgfs49. pdf >. bis

central bankers ’ speeches but, once again there is a balance to be struck. the recent problems in cyprus give us a hint of this. the cypriot banks were very heavily deposit funded. this turned out to have two distinct disadvantages. the first was that when the value of the banks ’ assets fell, depositors had to bear the brunt of losses after the equity holders. this significantly complicated the resolution of the banks ’ problems. a similar tension is currently evident in some of the international policy discussions. in particular, some regulators want banks to have more deposit funding because it is seen as more stable. at the same time, others want heavily deposit - funded banks to rely less on deposits and issue certain types of wholesale debt to make it easier to resolve a problem should it occur. the second disadvantage is that with only limited wholesale liabilities, the cypriot banks were arguably subject to less market scrutiny than were banks with a different funding structure. one benefit of wholesale funding is that the issuing bank needs to keep turning up to the market and selling its story to sophisticated investors. there is no guarantee that this extra scrutiny will prevent problems, but it is likely to help. the general point from both these examples is that there are tensions in financial regulation. regulations are introduced to address one issue, and another issue emerges. many countries have had the experience of regulating one aspect of the financial system only for other parts to grow very quickly, and problems to emerge in those other parts. i do not want this to be interpreted as a counsel of despair. but we need to be cognisant of the limits of rules alone. it may well be possible that a set of rules could be introduced to ensure that the specific problems of recent times are never allowed to occur again. but what is much less certain is whether these rules could ensure that a different set of problems, but with broadly similar consequences, do not emerge at some point in the future. i suspect that it is simply not possible, or in fact desirable, to regulate a modern financial system to the point that we can say with absolute confidence that problems will not occur. what we can do, however, is to reduce the likelihood and severity of future problems. if we are to do this on a sustainable basis, we need to look beyond rule - making, as important as that is. in particular, any set of rules needs to be accompanied by strong risk management frameworks, both within financial institutions and within the regulatory community. a critical element of these