If not addressed, this pro-cyclicality could erode the solvency cushions that banks should be holding against the effects of economic downturns. Addressing this is one of the most important remaining challenges of Basel II and is particularly associated with the implementation of the more sophisticated approaches of the new capital framework. Despite reassuring noises from the Basel Committee, this is not going to be an easy problem to address. Few people, and definitely not banking supervisors, can foresee the peaks and troughs of economic cycles. But our inability to perfectly foretell the future should not be a pretext for inaction. An effective supervisory review process will be critical to create a counter-weight to the cyclical tendencies of the new capital framework, in order to prevent increased incidences of failures and financial instability. Managers of banks and bank directors have an even more important role to play. They have the primary responsibility for identifying and assessing various threats to solvency of their own bank, including the risks that are partially covered or not covered at all under Pillar 1 of the framework. They also need to be cognizant of the cyclicality arising from their quantitative tools and should have sufficient compensatory mechanisms against the cyclicality of regulatory capital requirements. These issues are referred to in Pillar 2 of Basel II. This is what we refer to as “Supervisory CAR”, to address risks not covered or not fully covered by the formulae in Pillar 1.
Second, we are seeing a rapid change in the economic environment, with inflation switching from being very low to being extremely high. History suggests this can leave a scar on expectations. For example, research finds that differences in inflation expectations between people from the former East and West Germany can largely be explained by the lasting effect of the inflation shock after reunification. This contrasted strongly with the perceived norm of zero inflation in the German Democratic Republic and seems to have led former East Germans to over-adjust to an environment of rising prices. [16] This imperative to anchor inflation expectations helps explain why, over the last two policy meetings of the ECB’s Governing Council, we raised our key interest rates by 125 basis points in total. This is the fastest change in rates in our history and it has sent a strong signal of our determination to return inflation to our medium-term target in a timely manner. This major step also took into account the unusually low level of interest rates and the limited risk of overreacting at the start of the hiking cycle. Going forward, the appropriate pace of future rate increases will be decided on a meeting-by-meeting basis. Indeed, as we have repeatedly emphasised, we will remain data dependent in all scenarios. Where rates ultimately settle, and the size of the steps that we move in, will depend on how the inflation outlook evolves as we proceed. Conclusion Let me conclude.