In the Financial Stability Forum, which is leading the international regulatory response to the crisis, we are also looking at the scope for “macro prudential” instruments to dampen the destabilising procyclicality in financial markets. To do this we need to do more than simply raise the minimum levels of capital and liquidity that regulators, rating agencies, or the markets require. We need to create reserves based on macroeconomic factors, which can be drawn down as the cycle turns down and have to be replenished on the upswing when profits are high. The system of dynamic provisioning in Spain seems to work effectively in that respect and may well offer a guide for the way forward. Conclusion To conclude, on monetary policy, we have one instrument, and one goal – ensuring that inflation stabilises at target in the medium-term. While we must remain vigilant for any signs of inflation expectations drifting upwards, the news on that front is encouraging. On the other side, the risk we must be careful not to underestimate is the deflationary consequences of the credit crisis. At the moment we are focused on the risk that the slowdown in the real economy will be amplified through a contraction in banks’ balance sheets. But we should also set in place longer term measures to prevent such financial imbalances from building up again in the next upswing. In my view the case for macro-prudential policies alongside monetary policy is compelling.

Chart 1: Commodity Prices  Chart 2: CPI Inflation Percentage points 5  Index: Jan. 2007 = 100 300  Energy Food and non-alcoholic beverages CPI (per cent)  Brent oil price Wholesale gas price  250  4  Economist food-price index 200  3  150  2  100  1  50  0  0 Jan 07 Apr 07 Jul 07 Oct 07 Jan 08 Apr 08 Jul 08  6  -1 2004  2005  2006  2007  2008  BIS Review 114/2008  Chart 3: Inflation expectations  Chart 4: Three month Libor spreads  Per cent  5 5-10 years ahead [YouGov/Citigroup]  4 3  Basis points Sterling  180  Euro  160  US dollar  140 120 100  2 12 m onths ahead [Bank NOP]  12 m onths ahead [YouGov/Citigroup]  80 60  1  40  0 2003  2004  2005  2007  20  2008  0 Jan Mar May Jul 2007  Chart 5: Credit conditions on mortgage lending  Sep Nov Jan Mar May Jul 08  Sep 09  Chart 6: Feedback effects (I)  Net percentage balances(b) Factors contributing to 60 changes in credit availability  Credit availability  Changing economic outlook  Changing cost/ availability of funds  Weaker growth and falling house (and other collateral ) values  40 20 + 0  (3)  -  20 40  Bank losses (1)  Tighter credit conditions (2)  60 Q2  Q4 2007  Q2 08  Q2 Q4 Q2 2007 08  BIS Review 114/2008  Q2 Q4 Q2 2007 08  7  Chart 7: Feedback effects (II) Higher funding costs  Deterioration in the property market  Falling house prices  Increase in loss given default  Increase in credit losses  Squeeze on net interest income Erosion of capital ratios  Macroeconomic slowdown  Increase in default  Scarring effect on capacity  Increase in risk weights  Regulatory minima  Pressure to deleverage  Higher income gearing Tighter credit conditions  Chart 8: Liquid assets ratio  Chart 9: Leverage ratios of major UK banks P e r c e nt a ge of  35%  t ot a l a sse t s (all cur rencies)  30%  Maximum-minimum range Interquartile range Median  Ratio 65 60 55  25%  50 45 40 35 30 25  20%  15%  10%  5%  1967  1972  1977  1982  1987  1992  1997  2002  Liquid asset s inclues: Cash, BoEbalances, money at call, eligible bills and UK gilt s.  8  20 15 10  0% 2007  97 98 99 00 01 02 03 04 05 06 07 08  BIS Review 114/2008