CHICAGO - It’s not just liquidity that is essential to keeping the markets running, it’s trust, Vanguard CEO William McNabb said during his keynote speech at the Morningstar Investment Conference Thursday.

And one critical component to regaining investor trust is to overhaul the regulatory system through the creation of a systemic risk council.

“After 9/11 the markets closed down but the financial system held together,” he said. “Buyers and sellers came together and deals happened on a handshake. Trust stabilized the market during a fragile time.”

But as the financial crisis persisted through 2008, there have been hundreds of examples when investor trust has been breached, according to McNabb. From the collapse of Lehman Brothers to the May 6 flash crash, investors have lost faith in the system, he said.

“It’s possible we’re on the brink of losing a generation of investors, those in their 20’s who are starting out during this volatile time,” McNabb warned. Those financial maxims today’s investors take for granted, such as buy and hold and diversification, are coming under question, he said: “Is buy and hold dead? Does balancing and diversification really work?”

Part of the problem, McNabb explained, is the “siloization of regulation,” which can be fixed by creating a systemic risk council that doesn’t just get together every quarter but breaks down barriers between regulators. He also said that he thinks there should be a systemic plan on how to unwind firms that fail despite appearing too big to fail.

As Congress struggled to reconcile the regulatory reform bill, the question that was being tossed around was whether there should be more or less regulation, but McNabb said this isn’t the question investors should be asking.

“More isn’t necessarily better. Less isn’t necessarily better. We need the right regulation so the markets work the way they were designed to work,” he said.

McNabb offered some suggestions on how to repair investor trust. The three building blocks of trust, he said, are simplicity, transparency and candor. Simplicity means that if an advisor can’t explain an investment thesis to a client in five minutes or less then it shouldn’t be in the client’s portfolio. Transparency is when investors know what’s in the funds and how they perform. And candor is being “up front, out front and honest to a ‘T.’”

If investment advisors, regulators and governments don’t restore trust in the system the ramifications will be monumental, said McNabb. One of the biggest consequences will be that the financial markets won’t work the way they are designed to work.

“One of the greatest differentiators between the U.S. and the rest of the world is the breath and depth of confidence in the U.S.,” he said. “If the world begins to question the sanctity of the U.S. as an economic superpower and as a result capital flow doesn’t happen as efficiently as in other markets than growth will slow and job creation will slow versus other economies.”

McNabb said he doesn’t want to see that happen for the country, for his company, or for investors. “One of Vanguard’s missions in life is to be champion of the individual investor,” he said. “All we can do now is focus on that end investor.: