These investors had two characteristics: they knew very little about having bought sub-standard financial assets and, through globalisation, they were all over the world, as importers of sub-standard financial assets manufactured in the United States. Seventh, as the property market in the United States slowed and property prices adjusted downward, the delinquency rates of sub-prime mortgages shot up. The ratings and the prices of structured products containing, or suspected to contain, sub-prime mortgages fell sharply, and the whole market froze, with no transactions and therefore no price discovery mechanism, making it impossible for those holding such financial assets to mark them to market and incur reasonable write-offs. Even the market for interbank funds showed signs of significant lack of liquidity as participating banks were unable to evaluate the credit risk of counterparties. Eighth, understandably many players involved in this chain of events got hit – many of the originators have had to be closed down, different investors have had to take large losses, etc. But of systemic concern was the situation of the financial institutions providing the backup lines to the conduits and Structured Investment Vehicles (SIV) involved in the manufacture and distribution of the structured products containing sub-prime mortgages. Put simply, they found themselves having to take back substantial assets for which there were no market prices. But their ability to do so was limited because they were operating with relatively low capital adequacy ratios, which was why they had pursued disintermediation through securitisation in the first place.

Therefore, the Central Bank must be attentive to steer monetary policy to avoid secondround effects on other prices, wages, or private sector inflation expectations due to supply shocks, that could end up driving inflation persistently away from the 3% target. Of course it also has to foresee the consequences of the business cycle over inflation. It also The efficacy of this monetary policy over the 2000s is evident (Figure 3). BIS Review 97/2007  3  Figure 3: Deviation of inflation from its target  Source: Central Bank of Chile. The international financial turmoil Regarding recent developments in world financial markets, the first thing to do is recognize that the adjustment they are undergoing is part of an overdue normalization process in credit risk spreads for a large variety of securities, and volatility levels of the riskier assets prices (Figure 4). In fact, for some time our Financial Stability and Monetary Policy reports have stated that a correction in risk premiums and an increase in market volatility were to be expected, because the good conditions would not last indefinitely, in particular given the monetary policy normalization period in the main economies that was already prolonging for some years. It is very likely that today we are witnessing precisely that correction in risk valuation and volatility. Figure 4: Sovereign risk premiums and volatility (basis points)  (1) Risk premium on developed market corporate bonds with less than investment grade risk ratings (CCC to BB), according to Standard and Poor’s.