Individual banks do not have an incentive to take into account a fall in value that it inflicts on its counterparties. Contagion effects are externalities between banks that can lead to a situation where the risk in the financial system becomes greater than the sum of what individual banks believe their risk to be. Over the past years, I have travelled around the country and visited many savings banks in Norway, and without exception they report that risk management has improved considerably at their banks. That is no doubt true, but I cannot without a doubt conclude on that basis that systemic risk has been fully eliminated. Herd behaviour amplifies risk in the financial system. The more banks’ portfolios are alike, the more they are exposed to indirect contagion through a fall in the market value of their portfolios. When banks have similar portfolios, they are also vulnerable to the same external shocks. The banking system as a whole becomes vulnerable. The assumption that banks are intertwined and alike can lead to problems spreading between banks through expectations alone. If depositors see problems in one bank, they will run to their own bank and withdraw their funds before it is too late. Paradoxically, banks become more alike when they apply the same diversification strategies. The savings banks I mentioned may have become more alike if they are using the same risk management systems. That banks become more similar may also be a sought-after result on the part of banks. They may want to move in herd.
Today, our mission is still to promote the good of the people of the United Kingdom, but now we do that by maintaining monetary and financial stability. Let me explain what that means. Maintaining monetary stability means two things. First, providing banknotes that you can use and trust. We have over 3 billion notes currently in use, and they are used in 44% of all transactions. Second, it means maintaining low and stable inflation. Maintaining financial stability means three things. First, making sure that when you put your money in a bank it is safe. Second, it means that if a bank fails, the costs fall on the bank’s investors and senior management, not ordinary people with deposits in banks. And finally it means making sure that if you take out an insurance contract, it will pay out if whatever you are insuring against happens. The work that the Bank does in all of these areas can ultimately be summed up very simply: we maintain confidence in money. This confidence is not, though an end in itself; it is a means to an end. Confidence in money provides the foundations for prosperity. Without it, companies would struggle to provide the goods and services we all use every day; you would face difficulties in knowing how to invest for your futures, be it financing studies or buying a house. Maintaining this confidence is the best contribution the Bank of England can make to the good of the people of the United Kingdom.