In April, the Chairman of the Financial Stability Forum (FSF), Governor Mario Draghi, summarised the view of the FSF when he said: “Our conviction is that […] institutions have accumulated a level of leverage that was both misperceived and excessive.” 2 Gerald Corrigan argues that “leverage, in its many forms clearly was a driving force in creating the market conditions that would trigger the crisis, just as the inevitable de-leveraging on the downside of the cycle would severely amplify the magnitude of the crisis.” 3 In a similar vein, the International Monetary Fund (IMF) stresses that the dramatic deleveraging of financial institutions is exacerbating the downward spiral so  1  See every issue of the Swiss National Bank’s Financial Stability Reports since 2003. 2  Mario Draghi, chairman of the Financial Stability Forum, in his address to the G7 ministers and governors, April 2008. 3  E. Gerald Corrigan, The Credit Crisis. The Quest for Stability and Reform, The William Taylor Memorial Lecture, Group of Thirty, Washington DC, 2008, p. 8. BIS Review 158/2008  1  prevalent in the current crisis. 4 Hence, by implication, the high starting levels of leverage are a major source of the severe and ongoing adjustment problems. Finally, the leaders of the G20 declared only last month that “excessive leverage” was a root cause of “vulnerabilities in the system”. 5 Moreover, the problem of excessive leverage is not limited to the current crisis. It has been a pivotal feature of most previous financial crises.
The risk here is that when the current external disinflationary pressures subside, domestic cost growth pressures will have built up and will push inflation above target before monetary policy can restrain it. I would not discount this risk. The labour market has clearly become much tighter. And if pay is being held down by cyclical or scarring effects, these could change quickly. And there has been a substantial depreciation in sterling in the past three months which will push up on inflation, possibly more quickly than the usual prolonged lag between changes in the exchange rate and inflation. But with interest rates near the effective lower bound, with powerful disinflationary forces from abroad likely to persist for the next year, with low growth in unit labour costs and with an economy growing at around 2%, I think this is the lesser risk. Second, there is the concern that continued low interest rates lead to the build-up of financial stability risks through an acceleration of credit growth, increase in bank leverage and household indebtedness. The financial system has only recently come back to life with economy-wide credit now growing in the UK at around the rate of GDP. While there are some elements of credit that are growing more strongly, such as buy to let mortgages and unsecured debt, I think we are now emerging from the post-crisis phase and in a more standard stage of the credit cycle and we now have macroprudential tools to manage risks as they build up.