There is however more to the story than that. In the period between the early 1990s and the onset of the crisis, there was a remarkable and unprecedented evolution of the financial system which involved a major expansion of activity. Banks moved from a traditional model of taking deposits and lending them out, to a model that involved far more the origination and distribution of loans – often known often as securitisation, in which these loans were substantially distributed to shadow banks. These shadow banks thereby took on more of the traditional core bank functions of credit assessment and maturity transformation (the practice  1  The Financial Stability Board has defined ‘shadow banking’, as credit creation occurring partly or wholly outside the banking system. In this lecture, I use the term ‘shadow banks’ in the looser sense of those entities in the non-bank financial system that might pose systemic risks in any form, collectively or individually. BIS central bankers’ speeches  1  of borrowing at shorter maturities than the maturities of the assets they held). And, they did so, like the banks, with weak levels of capital. But, it would be a mistake to portray shadow banks as bad. There is good evidence that in the twenty years before the crisis they emerged as a stabilising force (most notably in the US) because they were able to expand their provision of credit at times when traditional bank lending underwent cyclical contractions (Meeks et al 2014).
This conclusion has been reinforced in the recent publication of the Senior Supervisors Group (SSG) in which the PRA participates (Senior Supervisors Group (2015)). The SSG has concluded that “key supervisory concerns centre on whether the risks associated with algorithmic trading have outpaced control improvements. The extent to which algorithmic trading activity, including HFT, is adequately captured in banks’ risk management frameworks, and whether standard risk management tools are effective for monitoring the risks associated with this activity, are areas of inquiry that all supervisors need to explore”. As supervisors of almost all of the world’s major trading banks – through their operations in London – we can provide some helpful assessment of these events. We have observed that the balance between aggregate buy and sell orders submitted to banks’ electronic trading systems can shift instantaneously, and sometimes violently, upon this type of occurrence. 4  BIS central bankers’ speeches  The impact is often exacerbated by the simultaneous reduction in order book depth on organised multilateral electronic trading venues. The electronic trading contribution was more evident on 15 January, as a foreign currency market event than the 15 October (a bond market event), reflecting the different patterns of trading in these markets. On the 15 January, the ability of banks’ e-trading systems to hedge positions consistently through automatic risk management broke down as the necessary reference prices became discontinuous and unreliable.