This shift would not only dramatically alter service delivery channels but could also redefine the character and boundaries of markets. This view incorporates developments that increasingly transcend existing institutional patterns.

For example, financial claims, including loans and bonds, could bypass intermediaries to be bought and sold by electronic auction through global bulletin boards at minimal cost. Users and suppliers of financial claims may be networked together to exchange real-time data and documents. Payments systems may extend beyond the present deposit-based stores of wealth to broader credit-based systems linked to the security of other forms of wealth, perhaps including illiquid assets such as real estate.

Without taking a position on the likely path of change between these two extremes, the Committee did nominate a series of key changes that it saw as likely to occur over the next decade. These included:

• advances in information technology – which could erode the traditional roles of financial institutions;

• increasing entry of new participants offering financial services from abroad;

• emergence of new payments instruments and payment service providers -- possibly divorced from traditional deposit products and using new technologies and delivery channels;

• continued evolution of large financial conglomerates, using their brand and other strengths to provide a wide range of financial services;

• continuous changes in the way services are designed and bundled and allocated among group companies to minimise regulatory costs; and

• an increasing share of household financial wealth held in the form of market claims, particularly through superannuation savings and retirement income products.

On the basis of all this, the Committee recommended a new regulatory structure for Australia. In essence, they argued that the domestic financial network had become more fragile and exposed to financial crisis and was therefore in need of a local overhaul.

Without wanting to suggest that the Wallis Committee was the fount of all knowledge, many of the observations made in the Report are readily transportable from Australia to almost any developed economy, and indeed to many emerging markets.

Let’s take this local perspective and broaden it to the global financial system.

The first point to make is that, if domestic financial systems have become more exposed through technology – the same applies to the global system but greatly amplified.

In a recent paper, Woody Brock identifies five technological developments that he argues underlie the increase in international financial market volatility. They all have to do with the way market participants receive and respond to information in international markets.

1. Technology-based increases in the speed of response.

• In the past, news about fundamentals reached different investors at different times and their capacity to respond was limited by geography and high transactions costs.

• Today, there are no barriers to receiving information and acting on it quickly and cheaply.

• Consequently, the weight of transactions behind a given piece of news is much greater.

1. Technology-based increases in short-termism.

• Because technology has increased our ability to measure the performance of investment managers and to disseminate that information, he argues that the time horizon of managers has decreased greatly.

1. Technology-based increases in "Belief Correlation"

• As Brock puts it "our age-of-Oprah electronic media have created ‘A-team’ analysts, hedge fund superstars and economic commentators who achieve celebrity status and strongly influence expectations".

• Thus, he argues there is a much more concrete expectation about who will be disappointed about any particular piece of news.

• Consequently, there is a much greater herd mentality in markets – because everyone knows who is leading the herd and what their views are.

1. Technology-based increases in "Model Uncertainty"

• Brock talks a lot about the concept of model uncertainty. This is more than simply having an error term in your forecasting equations – it comes down to not even knowing whether you have the right variables in your equation – and even if you do, whether you have the right functional form.

• His point is that model uncertainty increases price volatility, and that the markets where model uncertainty are greatest are currencies, emerging market assets and derivatives.

1. Technology-based increases in leverage

• Brock’s main point here is that the growth of derivatives markets, both exchange traded and OTC, have greatly increased the ability of investors and financial institutions to leverage their positions.

In combination, these technology-related factors add up to a world in which capital flows quicker, flows in greater quantities, is subject to high levels of uncertainty and is potentially subject to herding.

You do not have to accept all these propositions to conclude that the fundamental fragility underlying the international financial system has increased – if only because the size of flows that the private sector can marshal have come to dwarf those of the official sector.

So where is all this heading? I believe the Wallis Committee got it right when they argued that the three critical shapers of the Australian financial system of the future are customer needs, technological innovation and regulation. The same, in my view, is true for the global financial system.

Consumer needs and here I define the needs of consumers to include corporates and governments will continue to grow on both sides of the balance sheet. Consumers will become ever more global in their thinking and ever more demanding of lower costs and top performance. The other area that is likely to grow is their need for risk management.

By itself, consumer needs is not especially daunting. The only two concerns that I would flag are:

• first, that the inexorable push for better value for money may push some institutions to operate too close to the wind thereby increasing the probability and frequency of failure. This seems to be an inevitable outcome of our drive for the "just-in-time" world.

• my second concern is that fickleness among investors can add to price volatility (as poorer performing funds managers are forced to exit positions, while the better performers absorb their investors) and it can add to the illusion of liquidity (as funds are forced to offer investors the right to exit).

Technology is a much bigger challenge. If Woody Brock’s story is even half right, then the next decade or two are likely to see a dramatic increase in the exposure of the underlying fragility of the global financial system. The frightening part is that much of this will come from technological innovations that have not even been thought about yet.

What then about regulation? The first point to recognize is that regulation both shapes financial evolution and responds to it. In the case of Australia, the Wallis Committee assessed the potential trends in the domestic financial system and recommended a new regulatory structure designed to best cope with the pressures that were likely to arise.

Discussions about a new international architecture are attempting to do exactly the same thing with respect to the global financial system.

Before I turn to the proposals that are under discussion internationally, let me summarise what they are grappling with. As I see it, the main issues are the following:

1. First, the exchange rate system.

• the international exchange rate system consists of a large group of currencies that float against each other,

• another group of semi-fixed exchange rate regimes that fix to either a single currency or a basket, and

• a group of countries that have adopted either a currency board or another country’s currency as a means of permanently fixing their rate

• the issue is that this system has shown itself to be fragile and crisis prone and is likely to become increasingly vulnerable over time what are the options?

1. Second, the international regulatory system

• what I have called the bonding devices between financial institutions in any given network that is, common regulatory systems, common currencies and common support schemes are becoming increasing blurred as indeed, are the geographical and industry boundaries between the institutions themselves

• the challenge for regulators is to redesign a structure that provides the protections needed and supports the exchange rate system that emerges and to do so before the existing structure becomes totally irrelevant.

Let me start with a brief summary of the New International Architecture discussions. So far, these have ranged over the various "G’s" G7, G22 and so on, and the latest creation, the Financial Stability Forum.

What is most notable about the discussions so far is that they have been long on dealing with issues of regulation, hedge funds, and capital flows but, as noted by The Economist magazine in summarising the state of play on the New International Financial Architecture in January of this year, "the official architects have been strangely silent about a crucial aspect of global financial reform: namely, exchange rates".

Perhaps the most obvious question to ask is if the Bretton Woods system worked so well in avoiding currency and banking crises, why don’t we simply restore it, or some variation of it? This is not an entirely silly question especially in view of those early comments by Bordo and Eichengreen.

The first thing we need to recognise about the Bretton Woods system is that it was established in reaction to the problems created by volatile international capital flows in the interwar period.

In response to the interwar experience with banking and currency crises, governments created an elaborate system of capital controls and regulations to reduce institutional risk taking and a system of financial safety nets in the forms of lender of last resort facilities and deposit insurance.

Under Bretton Woods, claims against countries’ foreign exchange reserves were dominated by trade flows and trade finance. What caused the Bretton Woods system to break down was that technology had made it possible for capital flows to overwhelm the underlying trade flows and, in the process, to overwhelm the capacity of sovereign governments to sustain convertibility.

For most countries, returning to Bretton Woods or a variant of it is not a realistic option – even if we wanted to wind the clock back, it would be largely impossible in most countries.

In the face of these observations, it is quite remarkable that the West pushed many emerging markets to liberalise their capital accounts and markets, ahead of more basic reforms in their economies. In doing so, these countries were exposed to the very pressures that had forced most Western economies to abandon fixed pegs only twenty five years earlier.

So what are the options?

The G7 proposal is not very helpful. It basically translates into the proposition that countries can adopt whatever exchange rate system they think is appropriate great help.

Let’s start with the majors. There can be little dispute that floating works for them at least in the sense of counteracting the underlying fragility. To understand how it resolves the fragility issue, consider the domestic banking analogy that I started with earlier. The offer of fixed convertibility of currency, backed by reserves, is the equivalent of a bank’s offer to liquidate deposits on demand, backed by limited liquidity. The floating rate equivalent for banks would be to issue all deposits as tradeable CDs, so that liquidity would be always available not from the bank itself, but from the market and at a price.

In this way, floating replaces fragility with volatility.

Does a floating exchange rate necessarily remove crises? The answer is - not necessarily. But floating does have two safety valves that can mitigate the impact:

• First, a floating exchange rate smoothes out the downward pressure by removing the one-way bets that occur between reserves-strapped governments and aggressive markets - and experience seems to indicate that smoother depreciations tend to be less volatile than those that follow head-on confrontations.

• Second, floating tends to be accompanied by more complete capital account liberalisation and the attendant growth in risk management instruments such as currency forwards and options - and, where the economy is largely hedged against depreciation, the likelihood of widespread bankruptcies is greatly reduced.

While floating removes the underlying currency fragility, and with it the potential for currency crises, it does not, by itself, remove banking crises. That is a matter for banking regulation and domestic support systems.

In reflecting on how this works, it is interesting to note how easily even a small country like Australia coped with its very substantial currency depreciation over the past couple of years. Our currency depreciated by over 50% over about 18 months, yet there was no loss of credibility for the government, no banking crisis, and not even so much as a decent reduction in economic growth.

We have a floating currency, a sound regulatory system and the RBA has credibility on inflation. But, more importantly, we were not making implicit promises to the market that we could not keep. New Zealand’s experience was very similar.

If we accept that floating resolves currency crises, then why shouldn’t all countries float their exchange rates? The answer appears to lie in the proposition that not all economies are large enough to absorb the volatility that accompanies floating. Indeed, some economies may not be large enough to sustain a successful float.

There is no definitive answer to the question of how big is big enough to float. Intuitively, the answer goes beyond just the issue of size. At a recent conference run by the RBA, Ricardo Hausmann of the Inter-American Development Bank spoke about what he called "original sin". He argued that a country suffers from original sin if it cannot borrow in its own currency in foreign markets and if it cannot support a long-term debt market in its domestic markets. He argued that a country with original sin cannot float, though he also conceded that such a country cannot sustain a fixed rate either.

I don’t know where the cut-off point for floating is. However, I suspect that it is likely to get bigger over time rather than smaller as technology supports capital flows of ever increasing size and speed.

What are the alternatives for those that do not qualify as legitimate floaters?

At the other polar end of the spectrum are currency boards and the more extreme solution of "dollarisation" a generic expression for adopting the currency of another country. In essence, these strategies, which do tend to have credibility, resolve the fragility issue by locking the exchange rate in place and forcing the domestic economy to adjust to international capital flows. In the same way that US capital flooded into Texas, and the Texan economy boomed when oil prices rocketed in the 1970s, and then collapsed when prices subsequently fell, so too are currency board countries treated like an extra state.

This can be fine if the small country has a similar structure to the country to which it links. This, however, is easier said than done. Again, Texas is a good example. Had Texas been a floater then, when oil prices rose, the "Texan dollar" would have appreciated against the rest of the US dollar, thereby dampening the oil price impact. When prices fell, it would have depreciated, again dampening the impact. But Texas was dollarised and the fact that the rest of the US was a net oil importer, put Texas’ interests and the rest of the US’ interests into direct conflict.

If floating works for big economies and up to a point rigid fixing works for small countries (and those that are happy to surrender their sovereignty), what about those in between?

The answer given by the new international financial architects seems to be to bumble on, be a bit more flexible, and maybe even consider capital controls.

I have already suggested that this semi-fixed currency system is crisis prone and likely to become more so. Thus we should ask - are there any amendments to the system that might make it less fragile? The best way to think this through is to return to the domestic banking analogy, since it is subject to the same fragilities and moral hazards.

How do we handle the fragility and moral hazard in banking?

We handle liquidity crises by a combination of:

• Liquid reserves, and

• Lender of last resort facilities

We handle solvency crises by a combination of:

• Deposit insurance, and

• Stand-fast arrangements

Finally, we handle the moral hazard problem by prudential regulation.

What are the international counterparts of these? In short they don’t exist. Further, in my view, the suggestions of the new international architects don’t even come close to providing them.

Their suggestions amount to a combination of assertions that emerging markets should accumulate more foreign reserves and suggestions that the IMF might arrange contingent credit lines for some undefined A-team of borrowers.

The bottom line of this one is that it is a bit too hard. There is no real enthusiasm, especially from the US, for the IMF to play a bigger role. While the system, as it currently exists, needs an official lender of last resort, the political realities of creating one are too difficult to overcome.

One of the difficulties is that creating a viable lender of last resort function is fundamentally dependant on simultaneously creating a suitable regulatory structure so as to minimise the problems that otherwise arise from moral hazard. It is one thing to suggest that individual countries should improve their regulatory arrangements, it is something else to establish an international equivalent of domestic prudential supervision.

The first thing to recognise is that the entities in need of international supervision by the lender of last resort are actually the governments who, in turn, supervise their domestic banking systems.

There have been several suggestions for reform that address this problem. They are all, however, only partial solutions and none deals with the tricky issue of how we might prudentially supervise countries.

The solvency issue is just as difficult. There have been discussions about stand-fast arrangements and the need to sort out implicit insurance arrangements, but these are proving extremely difficult to come to terms with.

When it is all boiled down, the new international architects have taken the approach that if you can’t fix the system to cope with volatile international capital, maybe the solution is to try to stop the capital. Thus, they argue that there may be a case for capital inflow controls to prevent an excessive build up of foreign debt. In other words, try to re-establish that part of the Bretton Woods system that succeeded for a while.

Without suggesting that I want to refute the conclusion - because I actually think it has some merit in the absence of any other reforms - it is worth noting what an extraordinary about-face this represents. Three years ago, you would have been safe to say that the vast majority of economists and international agencies would have argued strongly, if not passionately, that capital controls, and financial re-regulation more generally, have no role to play in modern macro-economic management. But the experience of the past two years has changed that.

Let me turn finally to the matter of prudential regulation.

I have already pointed out:

• that prudential regulation is an essential element in the strategy for dealing with credibility and moral hazard in the international banking system; but

• that we are very unlikely to get an international equivalent of a prudential regulator.

Improved prudential regulation is nonetheless a central plank of all discussions about the new international architecture. What can we reasonably hope for? I’m afraid I am not very optimistic on this one.

Let me start with the problem of inadequate regulation in emerging markets. My first point is simply to note that today’s developed countries did not build their regulatory and legal institutions overnight. A sound regulatory system builds on a sound financial system.

For example, we take for granted in Australia that our banks have a ‘credit culture’. This makes it easier for APRA to enforce a credit risk management regime. It means that we talk the same language. Indeed, much of APRA’s expertise is learned from the market itself and from seeing practical risk management systems in operation real risk management is difficult to learn from a textbook.

In this sense, a good regulator is often a follower of the best institutions in the market. Its role can be seen as shepherding the weaker institutions into line with market best practice. If local best practice is well below world standards, as is the case in many emerging economies, the regulator faces an uphill battle. The battle is even tougher when the regulator is unable to match the market in bidding for a small pool of highly-skilled staff. It is even tougher still when the market lacks the basic accounting and legal skills necessary for managing modern financial institutions these can take decades to establish.

So where does this lead us?

Certainly not to throwing our hands in the air and saying it is all a bit too hard! I see two messages in this assessment.

The first is that we must be careful to be realistic about what we expect of the regulators and regulatory reforms in these countries. We in the West must also be careful about imposing our institutional structures onto them. They need to crawl before they walk and walk before they run. You can have the fanciest regulatory structure in the game, but without the skills to operate it and the skills in the marketplace to manage finance, it is all a big waste of time and energy. We need to start with the basics and build from there.

The second message is that those with developed regulatory systems can help. Not only can we help we have an obligation to help. That help can be as intensive as helping with reforms and building training programs, or as simple as allowing other regulators to send staff to spend time in our institutions to see first-hand how it is done in other countries.

In short, upgrading national regulation is a long hard road, but one that needs to be hoed.

And what about regulation in developed financial systems? As I noted earlier, the fact that bonding devices between financial institutions in any given network are becoming increasing blurred creates an enormous challenge for regulators. This is perhaps best exemplified by the challenges posed by the internet, where products can already be offered across international borders with impunity.

These boundaries will become less distinct and less co-incident with time. I don’t know all the answers about how we will meet these challenges but I do know that we all need to be very careful to limit our implicit liability by not extending the regulatory imprimateur any further than we absolutely have to.

The most obvious context for this comment is the recent suggestion from some quarters that prudential regulation should be extended to hedge funds.

There are at least three good reasons why I don’t think these unregulated institutions should be regulated at least not by APRA or its counterparts overseas.

• First, they are much too complex for regulators to keep up with. It is one thing to use your hand to regulate the flow of water down the plughole in the bathtub it would be something else to use it to try to stem the Yangtze in flood.

• Second, regulation implies (whether we like it or not) a degree of government imprimateur. People know when they put their money in a bank that there is a high probability that the promise the bank is making will be honoured. This confidence is boosted by the fact that there is a government-appointed regulator behind the bank watching the prudence of its financial activities. It would be courting disaster to imply such a level of confidence in high-risk investment vehicles such as hedge funds.

• Third, a degree of indirect regulation over these institutions can be achieved by regulating more closely the banks and insurance companies that provide them with the credit lines that enable them to take such big risks. I should hasten to add that this has not been a big issue here in Australia, but it has focussed the minds of a few overseas regulators whose institutions were excessively lax in their credit analysis of these highly-leveraged players.

While there is a strong case not to extend prudential regulation to these high-risk institutions, the case does not end there. Some of these institutions command enormous resources and have been able at times to move markets to their advantage. This is certainly a matter of great concern to market conduct regulators. Indeed, the push for greater transparency from these institutions is a rational regulatory response from the appropriate regulatory quarter.

I have covered a lot of territory in the past hour. Let me try to sum up briefly.

1. First, in taking crises as my theme, I have argued that the holy grail for the architects of the international financial system is to construct a system that minimises the potential for financial crises to generate economic crises.

2. Second, I have argued that currency crises and banking crises share a common foundation. Both arise from the same fundamental fragility that accompanies any system in which institutions or governments make promises that are difficult to keep. There are lessons in this parallel that I don’t think have been fully absorbed.

3. Third, I have argued that the changes that have been taking place in the global financial system over recent years in terms of changing consumer needs and technological innovations while not the direct source of crises, have added to the fragility. More to the point, these same sources of change are likely to continue to add to international fragility in coming years.

4. Fourth, I have argued that those responsible for the new international architecture have not adequately addressed the fundamental fragility in the international exchange rate system.

• they have not adequately addresses floating as means of resolving fragility, and

• they have not adequately addressed the international regulatory structures needed to counter the fragility and moral hazard problems of continuing with the existing system.

1. Fifth, I have argued that improved prudential regulation - while not the main game in town - is an important part of any scheme to reduce fragility in the global financial system. Regulation is as much a shaper of the evolving system as are changing consumer needs and technological innovation. Indeed, a key role for regulation is to play a counterbalancing role to the instabilities and crises that might otherwise arise from the other two. On this one I believe that we must be realistic. Regulation has an enormous task ahead - improvements in emerging markets will be slow, while regulatory innovations in developed markets will be chasing an increasingly elusive objective.