6  The model, developed by the economist Robert Barro, and based on an earlier idea by Rietz, allows for the effects of one-sided tail risk – the potential for macroeconomic “disasters” – as well as more conventional, two-sided uncertainty (Barro (2009)). The downside skew to growth reduces the risk-free interest rate and pushes up the required return on risky assets. I used this model to speculate about the causes of low investment in a speech a couple of years ago (Broadbent (2012)). BIS central bankers’ speeches  5  simulates a 1%-point decline in expected future growth). They also return less from that point on. Qualitatively, increases in uncertainty have similar effects – they reduce equilibrium interest rates and depress equity prices (Charts 6(c) and 6(d)). But their sizes are rather different. Changes in two-sided uncertainty don’t do that much (6(c)); by contrast, small rises in the perceived chance of very bad economic events can have powerful effects on the risk-free interest rate.7 Intuitively, this makes sense: an asset whose payouts are immune to such disasters are valuable. Even if that downside risk rises by only a little, people are prepared to pay quite a bit more for – and to tolerate lower returns on – the “safe haven” of government debt. And I think it’s plausible, at least, that an increasingly negative skew to global growth expectations might help to explain the divergence between equity and bond yields in Chart 2.
Ensuring that Banks Continue to Serve the Real Economy While the effect of regulatory reforms on the broader economy has so far been benign, regulators must continue to pay close attention to the cumulative effects of various reforms and seek to minimise adverse consequences for the real economy. Let me highlight two areas that bear close watching: •  First, profitability in the banking sector. •  Second, distribution of credit to key segments of the economy. BIS central bankers’ speeches  3  Bank Profitability is Important for Bank Stability Let me start with bank profitability. Regulators are not in the business of ensuring profits for banks. But we have an interest in the profitability of banks for two reasons. First, banks need to be profitable in order to be strong. •  Retained earnings are one of the major sources of equity, which is in turn the highest quality capital held by banks. •  Healthy capital buffers in turn improve the resilience of banks against losses. Second, banks need to be profitable in order to be able to support the real economy. •  Banks have to earn a decent return on their credit intermediation role. •  A study by the Bank for International Settlements shows that banks with high capital ratios at the start of the Basel III process and strong profitability in the post-crisis years have tended to expand their lending more.