For instance, scenarios should take account of the extent to which many firms might respond to a common shock in a similar way, with potential implications for market prices or market liquidity. The likely amplification of price moves as financial institutions attempt to exit “crowded” trades and liquidity dries up is an important example. Indeed, given the importance of market liquidity for the efficient execution of banks’ dynamic hedging strategies and for their activities in the wholesale funding and credit risk transfer (CRT) and securitisation markets, it is essential that stress tests factor in extreme, yet plausible, scenarios for liquidity conditions in these markets, recognising that market liquidity can evaporate very quickly, particularly for complex structured financial instruments. And it is also essential to factor in increased liquidity needs linked to contingent calls, associated, for instance, with funding margin payments. Capital and liquidity buffers A sizeable buffer of capital and liquidity can help a bank to withstand a shock that threatens its solvency or would otherwise leave it with insufficient liquidity to meet its obligations as they fall due. But a bank’s private choice as to the size of its capital or liquidity buffer may not be aligned with the socially optimal choice, as firms will not naturally take account of (or “internalise”) the implications of their distress or failure on the financial system more broadly – for example through the possibility of contagion to other firms and impairment of the financial intermediation system. That provides the justification for prudential regulation.

I will not dwell here on the value and importance of capital adequacy standards in containing systemic risks – enough has been written on the Basel Accord and Basel II, such that this is well understood. However, consistent with my earlier comments on stress-testing and the importance of modelling behavioural responses, it is crucial the authorities understand banks’ likely responses to changes in minimum capital requirements over the business cycle. In this regard, the Bank and the Financial Services Authority (FSA) have recently developed a framework for monitoring the potential for procyclicality in credit conditions. The Basel Committee on Banking Supervision and the Committee of European Banking Supervisors are working on similar frameworks internationally. 2  Financial Stability Report (April 2007) (http://www.bankofengland.co.uk/publications/fsr/2007/fsr21.htm) & FS Paper No.2: “A new approach to assessing risks to financial stability” (Haldane, Hall and Pezzini) (April 2007) (http://www.bankofengland.co.uk/publications/fsr/fs_paper02.pdf)  2  BIS Review 77/2007  Capital adequacy standards are usefully complemented by “large exposures” rules. In particular, the application of such rules recognises the importance of addressing the risks from an unforeseen event that could cause a bank to incur serious loss, and that major problems could spill over from one bank to another given the network of interconnections. A European Union-wide review of the Large Exposures Directive is underway, offering the opportunity to improve the resilience of the financial system to such spill overs, including in the inter-bank market. Rather less has been written about liquidity buffers and prudential liquidity standards.