The banking system was not transparent enough and had to be more tightly regulated in the wake of recent global scandals, says Reserve Bank of Australia's (RBA) deputy governor Philip Lowe.
However, just inventing rules was not enough because they could be ignored and banks also had to be closely supervised, especially when it came to their risk management practices, said Dr Lowe.
US Bank JP Morgan recently revealed $2 billion in losses, while Britain's Barclays Bank has admitted to manipulating the London interbank offered rate, with both cases involving complex derivatives trading instruments.
Both cases also angered the public, highlighting greed and dishonesty and incompetency about risk.
"Financial institutions have managed things so poorly that at a community level one can understand why society wants someone to do something about it," Dr Lowe told an economists conference in Melbourne.
"The banking system wants regulatory pressure, political and community pressure to ease off a bit, but while trust doesn't exist our society quite rightly is demanding politicians and regulators do something.
"It strikes me as very hard for someone out of an institution to assess its risk management when even the people inside with all their skills and information can't make that assessment."
However it was important not to tighten the regulatory screws on financial institutions too much or the cost benefit sum would fail, pushing activities off balance sheets and into the unregulated shadow banking sector, Dr Lowe said.
"Supervisors must be willing, and able, to act and constrain activities that pose unacceptable risks to the financial system," he said.
Judgment, not rules, were the key with Australia reasonably well served in that sense by the RBA, Australian Prudential Regulation Authority and Council of Financial Regulators, he said.
Australia's four major banks are regarded as among the world's most profitable, with all four in the world's top nine banks as judged by ratings agencies.
However APRA's chairman John Laker suggested there should still be penalties for highly paid executives that got risky bets wrong as there were remuneration incentives when they paid off.
Meanwhile, Dr Lowe said the RBA had cut the official interest rate more than it otherwise would have needed to over recent years to offset rises in bank funding costs.
The cash rate of 3.5 per cent was about 1.5 percentage points lower than it would have been had commercial lenders felt able to pass on in full all the official rate cuts, he said.
Keep reading - next article