So the priority is ensuring that all agents are well-prepared and preventing harmful feedback loops between the real economy and the financial system. Rising insolvencies will certainly leave a mark on banks’ balance sheets. Corporate insolvencies lead to credit defaults. This weighs on banks’ capital ratios. Banks may attempt to reduce their lending in order to stabilise capital ratios.
However, rapid expansion of balance sheets and the assumption of risks that were not properly understood created financial fragility in many financial institutions, including those which had been bastions of the financial establishment. Furthermore, the complexity of the modern financial system and opacity of many new financial instruments created enormous uncertainty among investors as to where risks were actually held.