more throughthe - cycle provisioning techniques that place institutions in a position to absorb losses rather than curtail credit during a downturn. • compensation issues – these have been much in the public eye recently : do bonusbased pay systems, for both traders and senior and top management of financial firms, reward short - term risk taking with little penalty for the longer - term risks taken to achieve profits? what are the elements of a sound compensation scheme? on this issue, the interests of regulators and shareholders broadly align but banks face a collective action problem. if there is a role for regulators and supervisors in this area, is it ex ante ( to adjust risk taking incentives ), and / or ex post ( to adjust capital to the risks taken )? • valuation and leverage : the interplay between these has become more important over time for a number of reasons, including more marketable assets ( especially credit ) that need to be marked to market, more market - based collateralized funding, more leveraged position - taking. but here too there is more we need to know about the mechanics involved. what effects have valuation practices and leverage had on the cyclicality of the financial system? acting through which channels? is there a possible or desirable course of action for the official sector? coming to the issue of monetary policy and financial stability – if the market turbulence tells us anything, it is that the pace of financial innovation in recent years, the volume of transaction in certain markets, the amount of embedded leverage in the system, and the global nature of finance, have transformed the functioning of the international financial system. these transformations were not fully appreciated in their implications for monetary policy making. central banks are inherently concerned with the health of the financial system. because of the critical role it performs – that of allocating capital and risk to the economy – a wellfunctioning financial sector is key for the achievement of primary macroeconomic objectives, such as stable prices and sustained growth ; for central banks, it is also fundamental for the effective transmission of monetary policy decisions to the real economy. contributing to the health of the financial system is, in a sense, encoded in the genes of central banks : one of the historical reasons for establishing a central bank was indeed to reinforce financial stability by having an institution that could act as a lender of last resort. the policy followed by the european central bank since the start of the turmoil is very much in line with this historical role. the ecb has not remained passive. it

mario draghi : how to restore financial stability lecture by mr mario draghi, governor of the bank of italy and chairman of the financial stability forum, at the 5th bundesbank lecture, berlin - brandenburgische akademie der wissenschaften, berlin, 16 september 2008. * * * as this crisis hits its first anniversary, it has evolved into an even more complex combination of rising inflation, declining growth, tightening credit conditions, and widespread liquidity tensions pervading the global financial industry. banks have raised a significant amount of capital to partly offset writedowns and credit losses. but they are now moving into a phase where credit losses in the banking book will begin to rise. and banks are entering this phase with weakened balance sheets. alongside a rise in credit related losses, the outlook for bank profitability is poor. the aggregate amount of capital in the system is great enough, under reasonable scenarios, to prevent the system as a whole from falling below regulatory thresholds. but the distribution of that capital obviously matters. and, for larger banks, the capital levels demanded by the market have gone up in response to the greater uncertainty and reduced transparency about their balance sheets. we estimate that banks are likely to need to raise at least once again the amount of capital raised since the crisis began. there are various reasons why some banks will be struggling to reach those levels. that is especially the case for the banks that ran the debt - financed, highly leveraged and maturity mismatched business model that provided steady fee income over the last several years. now their profitability looks impaired, and their desired deleveraging is likely to be happening through a reduction of new lending. capital increases are especially difficult in a situation of deteriorating stock markets where falling equity prices nullify the still significant efforts undertaken to delever banks ’ balance sheets. this has spurred increasing recourse to hybrid capital instruments, but these may raise in the future concerns about the quality of the capital raised. let me finally observe that the situation of the banks in the euro area is so far better than the one we are witnessing in the us and in other jurisdictions. as the crisis unfolds policies are taking a variety of shapes that can be grouped within two broad categories : emergency and structural responses. until now, the first remained typically national since each crisis was unique to the financial structure of the country and so were the remedies. however, if the crisis were to become systemic – and the past weekend has shown just how