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acity may stick to traditional banking. Some countries may find that their regulatory capacities may not enable them to allow the proper working of private banks and may decide to rely more on 'State-owned banks. If they decide to do so, they shouldn’t be discouraged by the claim that 'State ownership tends to stunt financial sector development, thereby contributing to slower growth' (World Bank, 2001). Many examples in developed economies have indicated that prejudice against State-owned banking is not justified and that 'sophisticated financial systems may badly fail. After all, the current crisis indicates that once the ships are down and all bets are off, all banks are public.

2.5 POLICY RESPONSES

There are two broad principles which should guide the search for effective, long-term policy responses to the financial crisis. The first principle is the recognition that enduring, sustainable reforms must mold the incentives of private actors such that the system sufficiently self-regulates. In other words, if policy makers want the market to work in such a way that institutions and individuals take fewer risks with their solvency, it is of paramount importance to have mechanisms in place and place that automatically raise the immediate costs of taking on such risks, and not to rely on regulators. The second is the central importance of what is known in engineering and risk management as “safe-fail” approaches ( Steil Benn, March 2009. P. 12). It is wrongly assumed that the system as a whole is made safe by making the individual institution safe. As indicated by the current financial crisis, prudent actions taken by institutions such as selling assets and ceasing lending, affect other prudent institutions in ways that might undermine the safety of all of them. Therefore, the requirements for securing the financial system are very difficult from those of improving risk management within individual institutions or individual countries for that matter.

Falling asset prices have caused much greater financial stress at major banks than capital regulation was supposed to allow. Recently, leverage at important financial institutions such as Bear Stearns, Lehman Brothers, and Citigroup, reached unprecedented levels. The current international capital adequacy regime for large banks 'Basel II' has three major flaws that must be addressed. The first is the pro-cyclicality of the requirements, which allows for ever-greater financial risks to be supported by a thin base of capital during good times, and demands a damaging curtailment of credit and a scramble for more expensive capital as assets are marked down in bad times (Steil Benn, March 2009). The second flaw in the Basel II regime is the role of officially sanctioned credit ratings agencies in assigning the risk ratings that determine capital requirements. The third flaw is the role of proprietary 'value at risk' (VaR) models employed by banks, and sanctioned by regulators, to determine risk levels on a portfolio basis.

2.5.1 CORPORATE FINANCE

The U.S. taxation system remains so highly favorable to corporate debt finance, and unfavorable to equity finance. Therefore, the U.S. economy will remain vulnerable to downturns in the credit markets. This disparity should be addressed as part of wider efforts to make the tax system less distortion in its effects on economic activity generally.
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