This has reduced their capacity and willingness to provide new loans, and a number of the largest financial institutions in both the US and Europe have had to raise substantial new capital. Crises and turbulence are built into the workings of the market. The search for yield and market shares may at times become too intense. One lesson from the turbulence so far is that developments in the financial system, with new financial products combined with a possible lag in legislation and regulation, have rendered the financial system vulnerable. The turbulence has also shown that in a situation of widespread uncertainty and turmoil, different segments of the financial market are interconnected, which is not evident under normal circumstances. An important aspect of the current turbulence is the sharp increase in the price of interbank liquidity. History shows that there have been periods where the spread between banks’ funding costs in money markets and risk-free interest rates has increased sharply, but these periods have been relatively short. The persistence of the wide spreads today suggests that banks’ confidence in other banks’ credit quality has been reduced. This would also indicate that banks prefer to hold substantial liquidity in order to limit their own funding costs. The persistently wide spreads is also an indication that this episode of turbulence is not yet a closed chapter. 2  BIS Review 45/2008  Orientation of monetary policy Monetary policy in Norway is oriented towards annual consumer price inflation of close to 2.5 per cent over time.
Compared with other countries, productivity gains have been particularly strong in the banking industry and other service sectors. The business sector has been quick to adapt and change, and to make use of new technology that is available in an international market. This is probably due the modernisation of the functioning of the economy through the 1980s and 1990s, which resulted in more efficient markets. Turbulence in financial markets The financial market turbulence may result in a reversal of some of the positive driving forces in the Norwegian economy. The turbulence was probably triggered by falling house prices in the US. There were reports of an increase in defaults on subprime mortgages from the second half of 2006. Securities portfolios had been developed around these mortgages. Uncertainty arose among bankers and investors who directly or indirectly were exposed to losses on these mortgages. This resulted in a sharp decline in prices for these securities, which then spread to a range of mortgage-backed instruments. In the course of summer 2007, it became clear that the losses had spread to banks, funds and financial establishments in Europe, Asia and the US. The turbulence also spread to other financial market segments. Few knew who was exposed to losses, and financial market participants started to question counterparties’ financial situation, and held on to their money. Many banks have sustained substantial losses on their own investments related to these markets, but have also had to bring back onto their books loans from companies they had established.