while infrequent, significant adjustments seem to be a feature of the system. the more important question, in my mind, is whether those adjustments destabilise the financial system and lead to very disruptive economic impacts. will adjustments lead to ‘ great financial crises ’ as they did 10 years ago or will the system be able to absorb the adjustment and perhaps even dampen its impact? in the first instance, it does not matter whether expectations are rational and are then significantly adjusted because of ‘ news ’ or whether they are irrational and extrapolative and get adjusted because reality has caught up. either way, the costs of financial crises can be minimised and perhaps avoided if the system is resilient to shocks that are possible even though they are very unlikely. and they can be further minimised if we can ensure that when the adjustment and loss occurs, other features of the financial system do not amplify and spread the stress. the great, post crisis, programme of reform of financial regulation, that is now well into its implementation had precisely this objective. much stronger prudential rules require banks to have capital and liquidity to enable them to take losses and withstand liquidity stress in excess of the losses and stresses encountered in the financial crisis. bordalo, gennaiolo and shleifer all speeches are available online at www. bankofengland. co. uk / speeches major uk banks now have capital ratios that are more than three times higher than before the financial crisis and their short - term wholesale funding has fallen from being more than 15 % of total funding in 2007 to less than 5 % today. in the uk, the financial policy and prudential regulation committees of the bank of england annually test the core banking system against a very severe but plausible stress – a scenario in which banks have to withstand a combination of ‘ tail risk ’ domestic and global economic and financial market shocks. 20 the scenario for the 2019 test, announced this week, includes a deep recession in the uk with gdp falling by 4. 7 % from peak to trough, house price falls of 33 %, falls in commercial real estate prices of 41 %, recessions in the euro area, the us, and china and market stresses including a 41 % fall in equity prices and a nearly 400bps widening of investment grade spreads. 21 last year, alongside the annual stress test, we also developed a worst case, disorderly brexit economic scenario to give us confidence that the core

adapt – that is, learn from the past without assuming that the future will follow the past. kahneman and tversky ( 1973 ) famously shows how humans are neither rational nor mechanical in making predictions, rather applying ( oft - mistaken ) judgment. williams ( 1987 ) reports various experiments testing how market participants form price forecasts, rejecting both rational expectations and extrapolative expectations models. see for example lovell university of chicago sovereign defaults are a fascinating example throughout history of the complexity of expectation formation – on the one hand, there are many examples of investors having long memories. louis xi faced a very high cost of borrowing because of repeated defaults and similar pressure encouraged william iii to the creation of the bank of england. on the other hand, there are many instances of investors lending repeatedly to sovereigns that have defaulted repeatedly. all speeches are available online at www. bankofengland. co. uk / speeches pedro bordalo, nicola gennaioli and andrei shleifer have recently posited a model of expectations that acknowledges our tendency to extrapolate from the past, but also allows for the use of forward - looking information. 19 it endeavours to integrate insights from behavioural economics into a rigorous economic model. they have embedded the work of behavioural psychologists that shows that while we do use news to form expectations of the future, we have a tendency to over - weight certain types of news. and that the way we remember can lead to certain risks being neglected or undervalued when we project the future. they use this model to explain the development of expectations in the run - up to the great financial crisis 10 years ago, expectations which they demonstrate were clearly not rational in the light of available information. the economic model they have developed – of ‘ diagnostic ’ expectations – is appealing because it starts from research on how humans form beliefs about the future, and how they act on those. the way in which investors and markets form expectations of the future is clearly an area that merits further research. as i will go on to discuss, it is important to those of us responsible for financial stability to understand what is driving the expectations of the future that underlie risk - taking and what drivers kick in when those expectations meet the future and have to be adjusted. macroprudential policy as i said at the outset, i expect the next ‘ crisis ’ to involve some form of over - valuation of assets, over - extension of credit and losses when this corrects.