It is a system centred on overnight and term credit to banks. So our system was tailor-made to be used as an instrument to resist a banking crisis. In the event, it was flexible enough to be activated – with only limited adjustments – in emergency conditions. The need to tackle the collapse of private arbitrage motivated two features of our enhanced credit support: first, the full, unlimited accommodation of banks’ demands for central bank credit at our policy interest rate contributed to repair the collapse of interbank lending; second, the extension of central bank credit provision to longer maturities, up to one year, was a substitute for market intertemporal trading. 5  For example, in late 2006 a new synthetic index became available for the first time which could be used to price sub-prime related tranches of credit derivatives. This new market price probably aggregated information about the quality of the underlying contracts, which was too dispersed or inaccessible before. This might have brought awareness of the precarious bases of the financial structures that were being traded. 4  BIS Review 29/2010  Our actions would not have been effective if they had not been enshrined in our mediumterm monetary policy framework. Our definition of price stability steered expectations in a sufficiently firm manner. So the ECB can dispense with making promises about the future path of the monetary policy stance. The ECB’s approach to steering market expectations is based on comparing inflation outcomes and projections with our quantitative definition of price stability.

The financial structures that we thought were in place to assess, absorb and neutralise risk were either dysfunctional, or worked – perversely – to magnify volatility. This is how financial risk was created, transmitted to the real economy and eventually became systemic. Key factors in creating this risk were opaque financial structures, particularly vulnerability to contagion and domino effects, and pro-cyclicality in financial markets. The lack of transparency in many financial instruments meant that market participants did not know who was exposed to what kind of risk. In this state of incomplete knowledge, some market players could exploit – for their own, private benefit – information that was not generally available. 2  Neil Wallace (1981) has an early theorem on the ineffectiveness of open market operations. Gauti Eggertson and Mike Woodford (2003) prove the irrelevance of liquidity measures at times of zero interest rates. See Wallace (1981), “A Modigliani-Miller Theorem for Open Market Operations”, The American Economic Review, Vol. 71 No 3, pp. 267–274, and Eggertson, G. and M. Woodford (2003), “The Zero Bound on Interest Rates and Optimal Monetary Policy”, Brookings Papers on Economic Activity, 1, pp. 212–219. 2  BIS Review 29/2010  Pro-cyclicality acts as a formidable accelerator of financial trends. Demand for finance increases and declines in tandem with the cycle. But the supply of finance does not simply accommodate demand: it often amplifies the cycle. Where does pro-cyclicality stem from? To my mind, distorted incentives and herd behaviour are key explanatory factors.