face value, at notice or at call. leverage changes the dynamics of any business. expected returns are higher but management needs to be on its game – which is an oft - quoted argument for having some debt in a corporation. in the case of banks, it meant that the business of banking became even more focused on monitoring, information gathering and risk management. of course the depositors had some protection in that the capital of the proprietors was at risk before deposits. but banks also undertook maturity transformation. they offered depositors liquidity, but held only a fraction of their own assets in liquid form – enough for normal day - today operations. the whole thing depended on confidence – if depositors wanted their funds back en masse, a bank could not provide them because its assets were not all in cash. if there was a loss of confidence for some reason, the bank would be under pressure : there could be a run. so banks themselves needed access to liquidity in situations of stress ; that is, they needed to be able to liquify assets when a shock to confidence occurred. when such a shock was idiosyncratic, a bank might seek funding in the market. other institutions, mindful of the possibility of contagion if a run got going, might support one of their competitors provided there was a reasonably held expectation of solvency. but if the confidence shock was more systemic in nature the question was how the whole system could be supported. this came to be seen as the proper role of a central bank and was ultimately encapsulated in bagehot ’ s famous ( if widely misquoted ) maxim that the central bank should be prepared to “ lend freely, against good collateral at a high rate of interest ”. 17 of course central banking was at that time embryonic at best : the central banks in existence in bagehot ’ s day mainly had been established to help sovereigns raise war finance ; their stability functions evolved later, over time. 18 but while the provision of liquidity in crises left the system less vulnerable to runs, it was no real solution to simple bad lending. even if all the good assets can be liquified to meet a run, if not all the assets are good, failure may still occur. failures of individual institutions could be allowed provided they did not damage confidence in others, but it is always difficult to know just how small or large a failure might cross the threshold. inevitably, since there could be spillovers from

##es were not detected. another counterweight is supposed to be the independence and scepticism of security analysts, but this was clearly compromised by the fact that the most prominent of them were working for investment banks which were sellers of securities and so had a strong incentive to look favourably on rising share prices. one could construct a long list of abuses, and a correspondingly long list of needed reforms. in various countries this is being done by governments and their agencies - particularly the conduct - of - business regulators such as asic ( australian securities and investments commission ) in australia or the sec ( securities and exchange commission ) in the united states. internationally, a lot of this is being co - ordinated by the financial stability forum. usually it is being pursued in the interests of investor protection and of ensuring the integrity of markets. but from my perspective, i see these reforms as serving the equally important macro - economic purpose of reducing the tendency for asset price booms to occur, or shortening somewhat their duration. i would not be so confident as to suggest that the reforms, no matter how well designed, would be able to prevent such booms, but any reduction in their extent will reduce the severity of the subsequent bust. i will conclude by making a comment about what we mean by a systemic financial crisis. usually, it means a series of bank failures, bank runs, and the government or central bank having to recapitalise the banking system. because of the improvement in banks ’ risk management and bank supervision, we have not even been close to systemic financial failure in any major country on this occasion. for this we should be thankful. but what we are getting instead are failures in the non - finance sector, enron, worldcom, etc., and more particularly a severe tightening of belts in the corporate sector with consequent contractionary effects on investment and employment. so the thing that is different this time is that the boom has not been followed by a financial crisis, but by an economic contraction as the most severely stretched parts of the economy seek to restore their balance sheets.