Much of this borrowing was short-term, giving rise to a maturity as well as a foreign currency mismatch, either on the part of the banks or the companies to which they on lent. When the initial pressure on currencies emerged, domestic borrowers that had previously never had to think about hedging their foreign currency liabilities rushed to do so, turning a slide in the currency into an avalanche. Those who were too late were left with liabilities to the banks that were vastly inflated in terms of their domestic currency - and the banks were left with the resultant bad debts and a crippled ability to finance the routine needs of their customers. Captive banks 7. Why were banks not more discriminating in their credit choices and decisions? Part of the explanation is that in a number of economies banks were ordered or persuaded by the government to lend heavily to particular industries and companies. In other words, they were “captive banks”. This allowed the companies concerned to become over-leveraged (and thus vulnerable to economic downturn) and directed resources into unprofitable investments. The banks concerned had little incentive to develop proper lending skills. Concentration risks and connected lending 8. Moreover, banks in some economies were over-exposed to single borrowers, often those connected with the lending institution. Such lending is usually of poor quality, not having been made at arm’s length, and means that the shareholders have no real capital at stake in the bank (because it has effectively been lent back to them).
The inflation target provides economic agents with an anchor for their decisions concerning saving, investment, budgets and wages. Households, businesses, public entities, employees and employers can base decisions on the assumption that inflation in Norway will be 2½ per cent over time. The inflation target is a vehicle for allowing monetary policy to stabilise developments in output and employment. This intention is also expressed in the Regulation on Monetary Policy. High demand for goods and services and labour shortages normally point to higher inflation. When interest rates are increased, demand falls and inflation is kept at bay. When demand is low and unemployment rises, inflation will tend to slow. Interest rates will then be reduced. The mandate implies that the interest rate must be adapted to the outlook for the Norwegian economy. If it appears that inflation will be higher than 2½ per cent with unchanged interest rates, the interest rate will be increased. If it appears that inflation will be lower than 2½ per cent with unchanged interest rates, the interest rate will be reduced. This orientation of monetary policy will normally also contribute to stabilising output and employment. The impact of monetary policy occurs with considerable and variable lags. The current inflation rate does not therefore provide sufficient information to determine the level at which interest rates should be set now. Our analyses indicate that a substantial share of the effects of an interest rate change will occur within two years. Two years is thus a reasonable time horizon for achieving the inflation target.