The paper argues that while attempts have been made to reform four of the five key pillars of banks’ operation, (i.e. competition, resolution, supervisory, and auditing and valuation policies), less attention has been paid to the role of bank governance and systemic risk, despite a strong link between governance and risk-taking. The paper offers four solutions to strengthen bank governance. First, the regulatory capital base of banks could be increased. Second, the compensation structure of managers could be reformed. Third, effort could be focussed on creating and implementing resolution regimes which offer the credible prospect of “bailing-in” creditors in the event of stress and fourth solution is to reform the structure of company law– for example, by extending control rights beyond shareholders. Furthermore, the paper argues that given the diversity of the whole financial system, it is expected that the risks individual financial institutions face are also diverse. It cannot be assumed that the appropriate capitalisation is constant across all risks. While leverage ratios are a useful backstop measure and guard against potential gaming of risk-weights, their appropriate role is as a backstop. The diversity within the financial system also supports the fact that a single measure of systemic risk is unlikely to be universally applicable, nor is a single instrument of financial stability policy.

This paper analyses various issues that need to be tackled when promoting financial stability, reviewing the progress made in certain key areas and the remaining challenges. It explores the measurement of systemic risk and of individual institutions’ contribution to it. It discusses aspects of macroprudential frameworks, including how the countercyclical capital buffer envisaged in Basel III takes into account the properties of the financial cycle and the strengths and weaknesses of macro-stress tests. It analyses some of the challenges of how best to monitor financial systems and the broader economy in order to detect signs of vulnerability that might lead to future bouts of financial instability and of how to set prudential policy accordingly. And it discusses the evolution of capital adequacy standards and the new emphasis on liquidity standards in international regulation.