Our worst financial crisis in living memory was the asset price boom of the late 1980s and its bursting in the early 1990s. Two significant banks failed, as did the second biggest building society, the biggest credit union, three merchant banks, a mortgage trust and a friendly society. You have to go back to the 1890s to find a worse period of financial failure in Australia. On this occasion, our banks remain well-capitalised, profitable and not exposed to subprime mortgages. Mortgage arrears in Australia are miniscule by world standards. That does not mean we will not suffer from world events, nor that some businesses will not get into difficulty.

Returning to the international scene, a number of explanations have been put forward for the severity of this crisis, starting with greed. But greed has always been with us, like original sin. My approach is to identify an observable excess and see what forces produced it. The two clear candidates are the degree of leverage in the financial system and the extent of bad loans. To my mind it is the former which was the main culprit, though the latter was also important. It is now apparent the degree of leverage (also known as gearing) in the system was grossly excessive, not, for the most part, in the non-financial corporate sector or the plain vanilla commercial banks. But there were few, if any, constraints on investment banks, hedge funds, investment banking arms of large commercial banks (think Citi and UBS), private equity, derivative instruments and other parts of "the shadow banking system".

Increasing leverage is the easiest way to increase returns in a rising market, and there were incentives to chase these returns and to ignore or downplay the risks. The biggest misdirected incentive was the performance-based pay which awarded massive bonuses to management of financial institutions on the basis of short-term profit results. Annual bonuses in the millions of dollars were not returnable when the short-term profits were lost in subsequent years. Highly-geared entities ignored or downplayed the risks. It was easy to do so because there appeared to be an unlimited amount of credit available, and it would always be easy to roll over maturing debt. But once doubts emerged about whether a highly leveraged illiquid asset was a going concern, the funding quickly dried up. If I have doubts about your solvency, I will not lend to you no matter how high the apparent rate of return.

Another factor behind the excessive risk taking was the mistaken belief you should be able to achieve double digit rates of return on an investment portfolio. It is true in the most buoyant periods of the 1980s and 1990s, those sort of nominal returns seemed to be effortlessly achieved, but they should be viewed as the exception rather than the rule. In more normal times such returns can only be achieved by taking very large risks, and then generally only for short periods. The average return on a diversified investment portfolio should be closely tied to the growth rate of nominal gross domestic product. In Australian terms, at present this means an average return of about 6 per cent. We will just have to get used tolong-run returns being a lot lower than was expected, based on the buoyant years of the 1980s and 1990s. The task of regulatory reform will be made easier by the fact that some of the worst excesses of the recent past are being taken care of by the market and the passage of time. The class of institution known as an investment bank is now extinct, the hedge fund industry will probably shrink to a quarter of its former size and the off balance sheet vehicles of commercial banks have disappeared.

We have to concede there was also regulatory failure, particularly in the US. Partly this is a result of their very fragmented regulatory framework, but partly it is also a result of insufficient scepticism on the part of regulators about what was going on. They placed too much faith in "science" and not enough in history. Ian MacFarlane, a former Reserve Bank governor, presented the Lowy Lecture last night in Sydney. This is an edited extract.