During an economic boom, rising asset prices facilitate increased borrowing through the higher value of collateral in the form of financial assets, houses and apartments. When the situation then turns, most likely associated with a tightening of monetary policy, the value of these assets falls and households’ financial situation deteriorates. If, in addition, the valuations have been over-optimistic, the price falls can be dramatic. The banks will in any case respond to the deterioration of both their own balance sheet and that of their borrowers by contracting their lending. During the following period of consolidation, inflation and economic activity will decrease. In a worst case scenario the banks’ loan losses will be large enough to threaten financial stability. Apart from the risk that expectations have been irrational, however, this kind of credit cycle is considered to be part of a normal adjustment process, which should be a component of forecasters’ informal and formal models. However, as the theory of credit cycles is not especially well-developed in the standard models that are taught in the field of economics, there is reason to suspect that the relationships are underestimated by forecasters. Other economists have pointed out that rises in asset prices that initially are justified by fundamentals, also attract short-term investors who contribute to pushing up prices. The longer the price rises continue, the greater the significance the speculators will have for price developments since investors with a longer investment horizon will no longer buy the assets.
Banks are increasingly providing technology services, such as account reconciliation software and “web-enabling” assistance, while technology firms are making inroads into services once the domain of banks and brokerage firms, such as financial planning and bill payment. Indeed, many banks are beginning to think of technology firms as competitors – or are contemplating ways to partner with them. I’d guess that most of us, perhaps even all of us, consider the advancement of computing and information technologies, and their role in the development of ever-more sophisticated financial instruments and techniques, to be decidedly positive developments. Such technologies, and the innovation they enable, have reduced the costs of financial transactions, improved the allocation of financial resources, increased the competitiveness and efficiency of financial institutions and markets, and opened new avenues through which individuals and institutions can better diversify and hedge their risks. But with this progress has also come new and difficult challenges. The rapid pace of technological advancement and financial innovation has introduced new, highly complex elements of risk, increased the speed and volatility of the markets, and blurred the barriers between previously distinct sectors of the financial marketplace. Even as supervisors confront change, the fundamental questions remain the same. Where is the risk in banks’ activities, and how effectively are they managing it? Where are banks extending credit and in what form? Who are banks’ customers, and how are those customers changing? To what extent are credit risks being transformed into liquidity and operational risks?