paul tucker : shadow banking, financing markets and financial stability remarks by mr paul tucker, deputy governor for financial stability at the bank of england, at a bernie gerald cantor ( bgc ) partners seminar, london, 21 january 2010. * * * many thanks for input to andrew bailey, michael cross, colin miles, victoria saporta, and for earlier conversations with david rule ( now fsa ) and bill winters. for background work to michael grady and for secretarial support to sandra bannister and cheryl feeney. this should be the crucial year in establishing a framework for a more resilient global financial system. much of the authorities ’ work is about how to do better in well - established areas of policy : bank capital requirements, liquidity requirements, supervision, and so on. but new areas are being debated, or revisited, too. those debates are more profound. they include whether we can develop macroprudential instruments and regimes for “ taking away the punchbowl ” from future financial - system parties before they get out of control. whether we can develop regimes for the resolution of banks and other key financial firms that can reinject market discipline into the financial system, while at the same time ensuring continuity of essential financial services to the economy in the event of severe distress at large, complex, cross - border firms. and whether the structure of the financial system needs to be constrained by the authorities. this evening i am going to focus on one part of the “ structure ” debate : shadow banking. it has become commonplace that shadow banking somehow exacerbated the boom, and complicated the rescue efforts of the authorities during the bust. 1 that is true. but there has been relatively little discussion about what this means for policy. we do not need to get too bogged down in defining what is meant by “ banking ” here. i mean it simply to refer to firms that take on - demand or highly liquid deposits, and use those liquid savings to provide term loans to households, firms and other parts of the financial system. banks are, therefore, absolutely central to the monetary and payment system ; and they are also vital to the credit system. they are leveraged ; they run maturity mismatches ; and their net worth is often uncertain. so they are exposed to runs, with spillovers to the rest of the system and the economy more widely. reflecting that, they have long functioned within the terms of an established social contract with the authorities. 2 it has involved

is probably the difficulty of distinguishing between changes in the quality and price of goods. in other countries, findings show that the consumer price index overestimates actual inflation to the order of ½ - 1 percentage point. the inflation target represents a framework for, not an obstacle to, monetary policy ’ s contribution to stabilising output and employment. this objective is also expressed in the regulation on monetary policy. if demand for goods and services is high and there is a shortage of labour, there will normally be prospects of higher inflation. when interest rates are increased, demand falls and inflation is kept at bay. if demand is low and unemployment rises, there will be prospects of lower inflation. the interest rate will then be lowered. in the long run, output is determined by the supply of labour and capital and by the ability to adapt, but in the short and medium term monetary policy can also have an impact on the real economy. the economy grows over time. output moves in waves. output will in some periods lie below long - term trend growth and in others above trend. the difference between trend output and actual output is called the output gap. stabilising output growth means seeking to maintain actual output near trend. we have had pronounced economic cycles in the norwegian economy. the downturn at the beginning of the 1990s was followed by an upturn from 1993. this upturn peaked in 1998. the economy then shifted from an upturn with high growth rates to an expansion with lower growth but low unemployment, labour shortages in many sectors and strong growth in labour costs. since 1998, output growth has been low. growth stalled in winter 2002 and was well below capacity in the first half of 2003. growth in the norwegian economy has since picked up. norges bank has not defined an exchange rate target. nevertheless, developments in the krone are of considerable importance to interest - rate setting because exchange rate developments have an impact on inflation and output. the krone fluctuates. this is not surprising because other countries ’ currencies also fluctuate. exchange rate fluctuation is a structural feature of open economies like norway that have their own currency. the norwegian krone does not stand out as particularly unstable. on the contrary, in countries like sweden, the uk, switzerland, australia, canada and new zealand, exchange rate fluctuations are as wide - or wider - than in norway. there is a cost involved for businesses in hedging against fluctuations in the krone. however, a