The liquidity of banks, as measured by the ratio of their most liquid assets (central bank reserves, gilts and Treasury bills) relative to total assets, was a fraction of what had been  BIS Review 100/2010  3  normal twenty years earlier and a tiny fraction of what had been normal before the 1970’s (Chart 3). And banks had also become larger. Their assets, relative to the size of the economy, had grown very sharply. Relative to GDP, they had roughly doubled in the 10 years up to 2007 (Chart 4). The UK banking sector had low capital, illiquid assets and was very large when fears about the value of its assets increased. The combination of those things accounts for the scale of the damage that ensued. Chart 4 UK monetary and financial institutions, assets as % of nominal GDP 600  500  400  300  200  100  0 1987  1990  1993  1996  1999  2002  2005  2008  Note: Monetary and financial institutions do not include insurance companies, pension funds and other financial intermediaries. Source: Bank of England, Monetary and Financial Statistics. There are many different proposals to build a more robust banking sector. Some of these involve using conventional monetary policy, that is interest rates. But most proposals are about changes to the way banks do business.
While it is too early to draw definitive conclusions from the current episode, it is nevertheless apparent that progress needs to be made by credit institutions, for example in the management of credit risk, market risk, liquidity risk, the risks associated with certain activities such as asset management and risks linked to the valuation methods used for some financial instruments. Regarding credit risk: –  It is important to check that banks’ internal rating systems, along with the estimation of the different risk parameters they use, are updated in order to reflect the increase in default risk and losses in the wake of the current turmoil. It is indeed vital that these systems do not lead to risk being underestimated. This update appears all the more necessary at the present time given that in the case of real estate loan portfolios, estimates of risk parameters have perhaps not been sufficiently rigorously tailored by all banks to the specific features of some risky forms of credit such as US subprime mortgages. The same thing may have happened in other countries.