The insurance premium banks pay for the deposit guarantee bears little relation to the risk the bank takes. In addition, since investors can expect that the authorities will come to the aid of banks in distress, they may be satisfied with a lower return. The result is an underpricing of risk, potentially leading to excessive risk-taking. BIS central bankers’ speeches  1  Low equity ratios reduce loss-absorbing capacity and, at the same time, strengthen the incentive to take risks. While owners cannot lose more than their equity stake, there is a potential for high returns on the equity capital they have invested. Banks’ owners lack incentives to take full account of the risk imposed on creditors. To avoid a situation where banks hold inadequate equity capital, banks are subject to capital requirements. Each bank should hold capital in proportion to its risk exposure. This is the basis of microprudential bank regulation. But even if each individual bank appears to be solid on its own, the banking system as a whole may be vulnerable. Risk in the system has several sources. Externalities between banks are one important source. Banks are exposed to one another and can inflict losses on one another directly. Banks can also inflict substantial losses on one another if they have shared exposures outside of the banking system. This was clearly evident during the financial crisis. When a bank is forced to sell off assets, these assets fall in value.
However, we must not believe that problems in the financial sector can simply be regulated away, and we must not have exaggerated faith in our ability to fine-tune the economy. But an important contribution will be to ensure that those who take financial risks on behalf of others hold more capital. Monetary policy has faced considerable challenges in recent years. We think it is important to learn from history and from the experience of other countries and to apply those lessons in the further development of monetary policy. This is why we are launching a research project, “Flexible inflation targeting: challenges and possibilities”. An important part of the background for this project is the fact that international monetary policy research has often focused on closed economies, with more relevance for large countries such as the US. Our small, open economy presents particular challenges. How does this restrict the room for manoeuvre in monetary policy? And how should monetary policy respond to changes in the terms of trade? The project will include analysis of some of the issues I have mentioned today. There is a need for more research on how financial stability should be taken into account in monetary policy. The project will also draw on the experience we have gained over the past 10–15 years as the Norwegian economy was exposed to a financial crisis and a number of supply-side shocks. Monetary policy communication is also developing. 11  See Bank of England: Monetary policy trade-offs and forward guidance, August 2013.