We must look at the institutions active in the financial markets; monitor how borrowers and other operators who could affect the banks behave and how the infrastructure supporting the financial system functions. It is difficult to determine which problems could constitute a threat to the system. Let me take the IT bubble in 1999 and 2000 as an example. If the banks had financed the many newly-started IT companies, they would have been hard hit when the air went out of this market. This would in turn have had repercussions for the real economy. However, it was not the banks who acted as venture capitalists here. This meant that the risk of shocks in the economy as a whole was less. Another example is what happened at Barings Bank a few years ago, when one of their foreign exchange traders speculated and lost around SEK 10 billion. The Bank of England refrained from intervention and did not provide the bank with any support, although a major bank was suffering serious problems that eventually caused its failure. This is because Barings’ problems were not expected to have any serious repercussions for the system as a whole and thus were not a stability issue. As in other sectors, bankruptcies do occur. This is normal and also important for market discipline.
Making this translation in the loss function, we see that the conservative central banker attempts to minimize the equally weighted sum of squared inflation and unemployment deviations: L = (π – π*)2 + 1 * (u – u*)2 where u and u* are the actual and natural rates of unemployment6 The bottom line is that a conservative and tough-minded central banker can still value deviations in unemployment from the natural rate equally with deviations in inflation from its target. Accordingly, an inflation rate of 5% against an inflation goal of 2% presents this  3  Taylor, John B. 1979. “Estimation and Control of a Macroeconomic Model with Rational Expectations,” Econometrica 47 (5) September, pp. 1267–1286. 4  For example, Woodford, Michael, 2005. “Central-Bank Communication and Policy Effectiveness,” Paper presented at Federal Reserve Bank of Kansas City Symposium on “The Greenspan Era: Lessons for the Future,” Jackson Hole, Wyoming, August 25–27, 2005. Available at: http://www.columbia.edu/~mw2230/JHole05.pdf  5  Rogoff, Kenneth S. 1985. “The Optimal Degree of Commitment to an Intermediate Monetary Target,” Quarterly Journal of Economics 100 November, pp. 1169–1189. 6  That is, Okuns’ Law says (y – y*) = 2*(u – u*), where u and u* are the actual and natural rates of unemployment. Making this translation in the loss function (so squaring and multiplying by ? = ¼ yields L = (? – ? *)2 + 1 * (u – u*)2.