Risk taking is central to the functioning of any financial system but the current crisis was brought on by excessive risk taking and a simultaneous decline in the risk absorption capacity of the financial system. Financial institutions have needed of billions of dollars of taxpayer funded public support because they did not have sufficient capital of their own.
Regulators allowed Capital, which acts as a shock absorber by absorbing losses, has been allowed to deteriorate over time both in quantity and quality. Even the discredited credit rating agencies have been using a more conservative definition of capital than lax regulators.
Under the current capital adequacy regime, regulatory capital requirements have been designed to converge towards the financial institutors’ own definition of capital adequacy based on dubious assumptions of institution self interest and market discipline. Since capital is costly, this regulatory complacence has driven a race to the bottom in capital holding by financial institutions.
Almost by definition, it is impossible to use market mechanisms to guard against market failure. Regulators need to make banks do something different to what they would do anyway; otherwise why regulate.
This erosion of capital is the other side of excessive leverage in the financial system which has the effect of amplifying both profits and losses and is responsible for the current fragility of the financial system and the speed of its collapse.
A parallel development has been the steady chipping away of mandatory liquidity requirements such as Statutory Liquidity ratios, which are still an integral part of the regulations in emerging markets such as India and have helped them withstand the worst impact of the crisis.
Because banks borrow short term and lend long term they are particularly susceptible to liquidity drying up. In this crisis, which arose out of excess liquidity in the financial system, liquidity disappeared both on the funding side as well as the asset side. That is why liquidity funding cushions and more conservative asset liquidity assumptions are part of the solution.