Triggering factors for the materialisation of risks and the exposure of vulnerabilities  I will now consider some possible factors that could trigger the materialisation of certain risks and the exposure of identified vulnerabilities. An important issue highlighted in the FSR relates to the existing ample financial market liquidity and the prevailing very low risk premia. One possibility is that an abrupt and sharp increase in risk aversion and a loss of confidence could lead to a substantial reduction in financial market liquidity which, as stressed, is currently abundant. Such a decline could expose several underlying vulnerabilities and trigger an adverse scenario which could involve: •  Funding liquidity challenges for highly leveraged financial institutions;  •  Unwinding of carry trades and possible unwinding of global imbalances;  •  Increasing credit spreads across the credit quality spectrum;  •  Increased asset price volatility in financial markets more generally; and  •  Reduced bank profitability as a result of lower trading revenues. A second adverse scenario could be triggered by a turn in the credit cycle or by a large credit event. This could lead to an unravelling of vulnerabilities in the corporate and household sectors and in credit markets that could involve: •  defaults of low credit-quality, high-leveraged households and firms;  •  significant challenges in the structured credit and CRT markets;  •  losses and potential failures of high leveraged financial institutions; and  •  counterparty risks for banks.
In addition, as we have moved far away from near-zero interest rates, it makes sense to shift 3/5  BIS central bankers' speeches  away from a focus on normalizing the stance of monetary policy relative to some benchmark “neutral” interest rate, often referred to as “r-star.” Now, I have spent a good deal of my career studying r-star and I find it to be a useful concept for describing the economy’s longer-run behavior. Having said that, at times r-star has actually gotten too much attention in commentary about Fed policy. Back when interest rates were well below neutral, r-star appropriately acted as a pole star for navigation. But, as we have gotten closer to the range of estimates of neutral, what appeared to be a bright point of light is really a fuzzy blur, reflecting the inherent uncertainty in measuring rstar.8 More than that, r-star is just one factor affecting our decisions, alongside economic and labor market indicators, wage and price inflation, global developments, financial conditions, the risks to the outlook… I think you get the point. Returning to the balance sheet, the question of what exactly the new normal looks like is still being analyzed and discussed at the Fed.