The implicit state guarantee for these institutions is a major source of incentive distortions. It is in complete contradiction with the functioning of a free market system and the hypotheses of our welfare theorems. Limited liability and the prevalence of bonus systems provide other significant distortions affecting individual decision-making. At various levels of financial institutions, decision-makers face asymmetric incentives. To give you an example, remuneration levels were high when risk taking paid-off, but there were no negative consequences – except possible job losses – when risks materialised. It is not surprising that excessive risk-taking was the consequence. 3  Domestic credit to private sector refers to financial resources provided to the private sector, such as through loans, purchases of nonequity securities, and trade credits and other accounts receivable, that establish a claim for repayment. Worldbank, World Development Indicators, http://data.worldbank.org/indicator/ FS.AST.PRVT.GD.ZS/countries/1W?display=graph. 2  BIS central bankers’ speeches  This problem of socially excessive risk-taking is even more damaging in the case of large interconnected institutions whose failure would endanger other institutions, with adverse consequences for the broader economy. Here, a clear externality is at work. My focus on incentive problems does not eliminate the possibility that cognitive or behavioural biases could also play a prominent role in driving excessive leverage in the banking sector. Herding behaviour and “group think” were certainly prevalent in “subprime investment”. A possible explanation for herding behaviour here is the propensity to suspect that “they know something that I don’t know”.
There are I think three reasons for this. First, it is in the nature of the shock – Covid itself does not destroy economic capacity over the longer term in the same way as a war, although of course the number of lives lost has been tragic. Second, the evidence here and in other countries indicates that the economic impact of Covid has attenuated with each successive wave – we are all by nature adaptive in our behaviour. For that reason, both in the UK and in a number of other countries, GDP releases during more recent periods of restrictions have typically surprised to the upside, relative to our expectations based on the effect of previous lockdowns. Third, the economic policy response has been designed to ensure that the longer term damage – often termed scarring – has been as small as can be. This has involved both monetary and fiscal policy pursuing their own independent objectives in a consistent and complementary manner. And just to be very clear on this point, when we use the tools of policy 1/5  BIS central bankers' speeches  consistently, and the objectives of policy are consistent, there is no compromise of independence whatsoever. So, we find ourselves now in a situation where there is an output gap, or slack as it is also called, but it is nowhere near as large as would be implied by the fall in demand if this was a normal recession.