When it became apparent that impaired loans were in circulation but that no one really knew where they were and to what extent, confidence in the banks disappeared. The market participants stopped lending to the banks. The banks also stopped lending to each other and when it also became impossible to sell previously liquid assets or to use them as collateral for loans the liquidity crisis had definitely arrived. One lesson that we have learned from this is how quickly liquid markets can become illiquid. We also know that the participants and the authorities underestimated how seriously the markets would be affected by the crisis. But, when the price of an asset falls it is no longer possible to borrow as much money on this asset. Participants are then forced to sell the asset to acquire liquidity. If many small – or a few large – participants sell at the same time then prices fall even further. From the point of view of an individual participant it is rational to decide to lend less or to sell the asset. However, the collapse in market prices that is a consequence of these decisions affects everybody. The impact this has on the market is, in other words, a negative external effect. Selling assets at “bargain-basement” prices should normally attract buyers. But exactly the opposite happened. There was uncertainty about the actual value of some complex and untransparent assets, which explains why the buyers disappeared.
At the same time, it is important that central banks and other authorities develop their ability to cooperate across national borders, particularly within the EU. Not least, we must learn to accept that someone will have to put their foot down when a cross-border risk develops, even though this may create a certain amount of fuss. The new European authorities – in the case of the banks primarily the European Banking Authority – are intended to act as arbitrators between national authorities on certain specific and limited issues. Although the right of the EU authorities to override the national authorities is limited, there are signs of a new tendency to transfer power to these international bodies. A risk council – the European Systemic Risk Board (ESRB) – is also to be set up in the EU with a special responsibility for the supervision of macro-financial stability. Even though the powers of the ESRB will be limited, this still represents an important step on the road towards a better consensus regarding the cross-border risks that exist and how they should be dealt with. An issue which in my opinion should be high on the agenda of the ESRB is lending in foreign currencies. Concluding remarks At the beginning of this speech I expressed the hope that we are heading towards a more stable and efficient financial system. The crisis has shown that we must reform regulation and supervision so that we can better prevent financial crises.