The prize will be an integrated framework, covering all our lending to the banking system and one that I hope, by making clear the terms on which liquidity will be provided in times of stress, will focus the minds of banks long before those stresses emerge. During my second term as Governor I would like to see us establish a framework for financial stability that is on as sound a footing as the one we have successfully established for monetary stability. The measures I have described would go a considerable way to achieving that. But just as no framework for monetary policy can prevent shocks from hitting the UK economy, we need to think carefully about why financial crises have been both persistent and damaging. That leads me to one final thought on which I want to end. For reasons of historical accident we have created over many decades a financial system in which the incentives to monitor risk-taking have been sharply reduced. It is often said that the role of a central bank is to take the punch bowl away just as the party is getting going. That approach has served us well in monetary policy. But all those efforts will come to naught if the opposite applies to the financial sector. If banks feel they must keep on dancing while the music is playing and that at the end of the party the central bank will make sure everyone gets home safely, then over time the parties will become wilder and wilder.
The effects on the international financial system were thus slight, although the crises affecting both Asia and Russia led to extensive redistribution of wealth and political tumult in the countries concerned. There are probably several reasons why the effects were so limited. One is probably that economic policy has become more predictable in many countries in recent decades, with sound public finances and stable, low inflation. The markets should therefore be less sensitive to shocks. However, another reason is actually that the financial system has become more resilient. The fact that risks have a better spread makes the system more stable. The risks are also transferred to the agents who want them or should have them. There is also the fact that the banks have gained more experience of operating in deregulated financial markets. The development towards more market-based transactions means that banks can now concentrate on the risks they are best at managing. They have also become better at managing them, with well-developed risk management methods and models. So far, so good. A better spread for risks and improved risk management can contribute to better absorption of shocks to the financial system. On the other hand, there can be elements that increase the risk of more serious shocks that also spread throughout the whole system. …or have they become more prone to risk? One such tendency could be an increased propensity among market agents to take greater risks and to copy others’ actions.