They cut back spending 16  more sharply as incomes and house prices fall, amplifying any downturn ; 17  Distressed sales of homes drive house prices down ; 18  Reliance on foreign capital inflows can expose the economy to global risks ; 19  And credit booms overseas can translate to crises at home . All of this economic analysis would still not have told us what would happen in 2007. It would not have allowed us to predict the roll of the economic dice. But it would have revealed that a bad roll would have very serious consequences. The financial system could have been stress tested against that. Its resilience could have been reinforced. It could have been prepared. What became a disaster could have been contained to a downturn. 5  All speeches are available online at www.bankofengland.co.uk/speeches  5  Now, with my second principle ringing in our ears, the toughness of our stress scenarios reacts not to whether a downturn is likely to unfold but to how deep it could be if it did. So when all appears bright – as real estate prices rise, credit flows, foreign capital inflows increase, and the last thing on people’s minds is a downturn – our stress scenarios get tougher. And my first call to arms for academia this evening is for further research into indicators that can help to guide us in asking how bad it could be.
However, recent empirical estimates for the UK suggest the effect is qualitatively present with the increase in banks’ overall funding costs due to higher capital requirements lower than in the absence of the theorem by 45% (Miles et al 2013) and 53% (Brooke et al 2015). 11 For example, the now defunct authority regulating the US Government-sponsored mortgage agencies stress tested them to only an 11% fall in house prices – a more severe shock than any nationwide house price decline to be found from 1945 onward. The peak-totrough fall of 11% was calibrated based on house price data for the West South Central Census Region between 1984 and 1993. Frame et al (2015) show that an alternative scenario based on realised post-2006 data would have revealed that Fannie and Freddie’s capitalisation was much weaker than what the original stress tests suggested. It wasn’t only regulators who made the mistake of relying on the recent past only. During a week when Goldman Sach’s Global Equity Opportunities fund lost 30%, Goldman’s chief financial officer famously stated: “We were seeing things that were 25-standard deviation moves, several days in a row.” His focus was too narrow. While the moves in 2007 were substantial, they were not unprecedented. Even within the last thirty years, equity prices had experienced larger single day falls than they did during 2007. 12 Danielsson et al (2016) show that systemic risk indicators constructed with market data were low and falling before the stress events in 1997 and 2008, and shot up during the events.