Small, open economies can be vulnerable to large capital movements when powerful instruments are deployed by large countries. A possible side-effect of balance sheet policy is that the private sector also takes longer to strengthen equity capital and reduce risk than it would otherwise have done. With the low price of capital, it costs little to postpone restructuring and put off debt repayment. Finally, confidence in economic policy may be affected. The dividing line between monetary and fiscal policy seems to be more blurred. Balance sheet policy may dampen the effects of market volatility on interest rates and give heavily indebted countries a breathing space and time to adjust. On the other hand, the measures may also reduce the incentive to carry out necessary fiscal tightening. In the euro area, different considerations are now being balanced in the new “Outright Monetary Transactions” (OMT) programme. Under this programme, the European Central Bank (ECB) may only purchase bonds from countries that have entered into a loan agreement under the European Financial Stability Facility (EFSF) or the European Stability Mechanism (ESM) – which in turn is conditional on a commitment to fiscal tightening. Chart: Corporate borrowing rates One reason for the ECB’s decision to establish the OMT programme is the partial breakdown of the monetary policy transmission mechanism in the euro area economy. There are wide differences in interest rates facing banks and firms across Europe. Although the same key rates apply to all the euro area countries, average corporate borrowing rates differ widely from country to country.

This suggests that the probability of such an event occurring would be no more than once in 300 years under even the very conservative assumptions. But the event had occurred within five years of LTCM’s birth. 7. It is natural, and indeed probably inevitable, that, in seeking to predict the probability of an event occurring, we tend to look to past experience. However, as we all dutifully warn investors when selling investment products, “past performance is no guarantee of future performance” and so we must stand ready to admit that there are fundamental limitations in our existing risk management tools. That is, the predictive powers of models are inherently restricted by historical experience. Where we encounter something new, such as innovative products or business model changes resulting in different forms of connectedness and creating different and new transmission channels, the models face significant difficulty in accurately estimating risk. Furthermore, even if one could find better models, any models must inevitably assume market behaviour remains constant to some degree, yet we know too well that uncertainty and panic may and do engender irrational or herd-like behaviour which a model struggles to accommodate. So, if the model’s findings can be “misguided”, too great a reliance on them, or too limited an understanding of what the model actually tells us, may result in a significant misjudgement of risk. 8. All of this prompts the question of how far we should reflect on the efficacy of our methods for assessing, measuring and managing risks in the financial system.