So, while we absolutely have to be alert to distortions, we are not crazy to infer, from yield curves, expectations about the path of policy rates or of inflation. But for financial stability, which of course affects macroeconomic conditions, I have always encouraged the team to do a Gestalt flip to thinking of markets as inefficient, riddled with preferred habitats, imperfect arbitrage, regulatory arbitrage, herding, and inhabited by agents with less than idealised rationality. That’s how during the early 2000s the team came to write about CDOs, ABCP, monolines and, eventually, vehicular finance etc. 2  Caballero R J (2009), “The “Other” Imbalances and the Financial Crisis”, MIT Department of Economics Working Paper No. 09–32. 3  See page 12 of Tucker P M W (2006), “Uncertainty, the Implementation of Monetary Policy and the Management of Risk”, a speech to the Association of Corporate Treasurers. 4  The potential risks associated with CPDOs (and other AAA-rated products) were discussed in the Bank of England’s April 2007 Financial Stability Report. 2  BIS central bankers’ speeches  Shleifer’s paper strikes me, therefore, as one example of exactly what the academic end of the economics profession needs to do in order to speak to policymakers framing and implementing reform. It engages with what I have previously described as “risk illusion”, in motivating a macroprudential prudential approach to policy.5 In other words, it carries policy implications.
Thankfully, all this is now also being worked on internationally in the Financial Stability Board. A second and obvious policy inference that one could draw from Shleifer’s paper, and one I want to spend a little more time on this evening, is that it is absolutely vital that (regulatory) capital requirements for banks more or less truly capture their risks. Two thoughts on that, of rather different kinds. First, it was very obviously a false step when, in Basel 2, the international-standard setters tried to follow the techniques and calibrations of private sector risk managers rather than engaging with the externalities that warrant State intervention in this area in the first place. Second, more particularly and more concretely, this underlines the vital importance of the current Basel work to review fundamentally the capital requirements for banks’ trading books. In short, Basel has recognised that the amount of capital a bank should hold against a liquid trading position often has good reason to be smaller than needed for a hold-to-maturity portfolio, ie where the bank can shed its exposure. But it failed utterly to recognise that since such books are marked-to-market (or model) and since the boundary conditions for solvency derive partly from accounting measures of asset values, it is vital that banks hold capital against the risk of violent swings in liquidity premia. Yet that is exactly what torpedoed a fair fraction of the largest banks and dealers in the world through their (levered) holdings of leveraged loans and super senior tranches of CDOs.