Many lending decisions are agreed weeks or months in advance and cannot be readily reversed. So the approach will not stem a very fast drainage of liquidity. Moreover, as one bank tightens lending conditions to restrict balance sheet growth, other banks facing similar pressure will react to limit any additional diversion of funding pressure onto their own balance sheets. The second is that a retrenchment in lending can have significant implications for the wider economy, as fewer funds are available to companies and households to support long-term investment and consumption. We are seeing some signs of that beginning to occur as highlighted in the most recent Bank of England Credit Conditions Survey. These defences suffer from a common shortcoming. While they may work well when one bank is facing funding pressure on its own, when liquidity pressures are widespread every bank will attempt to use them at the same time. The actions of one bank will work to negate those of a competitor in these circumstances as gains and losses of market share will net out. That implies an increase in the economy-wide costs of adjustment, posing increased risks to financial stability during the adjustment process. 2  See, for example, Bank of England: Financial Stability Report October 2007. BIS Review 50/2008  3  There is, however, one last line of defence left.
Moreover, new products emerged which also supported the transfer, hedging and dispersion of risks, such as credit derivatives. And the use of these instruments strengthened the inter-relationships between financial market participants across the globe: greater integration of markets went hand in hand with the acceleration of financial innovation and rapid growth of market activity. These developments helped stimulate important changes in banks’ business models. Constraints on growth were eased as funding sources widened. Many banks took advantage of new sources of wholesale funding available from securitisation – the packaging of loans into instruments which could be sold on in financial markets. In many cases, assets were routinely transferred into off-balance sheet vehicles which funded themselves through assetbacked commercial paper, with the sponsoring bank providing a back-up liquidity line. By applying this “originate and distribute” model, banks tapped a new source of funding on a large scale. More traditional and stable sources of funding, such as retail deposits, declined in importance (Chart 1). In addition, many banks saw opportunities to generate new sources of revenue and fee income by developing and deepening their activities in international capital markets. Innovation has provided banks with greater opportunities to hedge and diversify risks. For example, a regionally-based bank in country A can easily lower its geographical concentration, for example by selling credit risk to other investors who had not previously been able to access such exposures, and/or by purchasing exposure to credit risk elsewhere.