svein gjedrem : is the financial system stable? speech by mr svein gjedrem, governor of norges bank, at the 2001 annual meeting of the norwegian savings banks association, haugesund, 18 october 2001. please note that the text may differ slightly from the actual presentation * * * introduction the role of the financial industry in the economy has become increasingly important over the last decades. deregulation and technological advances have increased the industry ’ s opportunities and scope to channel savings to various projects. strong competition has induced the industry to make use of these new opportunities. the range of saving and financial instruments is becoming ever wider. systems and financial instruments for managing and controlling risk are becoming more advanced. as a result, it has become easier for households and enterprises to decouple consumption and investment from current income. in the second half of the 1990s, in particular, international capital markets have become more integrated. it has been easier for growing economies to finance investments through a balance - of - payment deficit and foreign capital. at the same time, countries with high savings can increasingly diversify their investments. globalisation places increasing demands on the business sector ’ s ability to adapt. new products and technology squeeze out old solutions. this creative destruction, as schumpeter called it, may foster a more efficient distribution of resources and higher economic growth in the long run. a rapidly changing environment places considerable demands on the financial industry. the financial prospects for a project must be assessed in relation to risk. a diversified portfolio of loans and investments limits expected losses. losses on one project may be more than offset by gains on another. economic growth is cyclical. during an upswing most projects fare better than expected. a deep recession can lead to heavy losses, insolvency and financial crisis. banks may address this risk by building up sufficient buffers during upturns. often, this is not done in practice. instead, financial enterprises tend to place special emphasis on increasing market shares while times are good and allow their capital ratios to fall. it is during an upturn that the basis for the downturn is laid. financial crises are often characterised by a first phase when optimism predominates, risk assessments weaken and the willingness to borrow and asset prices increase. when negative news starts to spread, investments fall short of expectations and the mood shifts, asset prices fall and debt - servicing problems accumulate. a financial bubble can first be identified with certainty after it has burst. there are

a growing number of examples of this. after the asian crisis, which started in 1997, and gradually had global spillover effects, there have been national financial crises in turkey and argentina. during much of the 1990s, the us experienced extensive restructuring and high economic growth. the gap between the us and the rest of the world widened. investment expanded sharply, particularly in the technology sector. this was made possible by dynamic credit and capital markets. developments led to a broad expansion in other sectors of the economy and other countries. restructuring and new technology may also have increased the long - term growth potential of the us economy. the marked turnaround that has now come shows that developments went too far. the technology stock bubble burst. the focus has now shifted towards heavily indebted households and businesses. banks are expecting higher losses. the question may arise as to whether financial crises are an inherent feature of a market - based financial system. what can the authorities and the financial industry do to reduce the likelihood of future crises? see bank for international settlements ( 2001 ). 71st annual report. basel i will take a closer look at certain crisis periods that occurred before world war ii and government responses in the form of legislation, regulation and the introduction of a financial safety net. in the decades prior to 1914, financial crises with a pronounced impact on banks were just as frequent as in our time. during the interwar period, financial crises occurred even more frequently. in the period of extensive direct regulation of banks up to the 1970s, there was a virtual absence of banking crises. however, the system was not sustainable and was at the root of many of the problems that followed. with a succession of crises since the early 1980s, financial stability has again become an issue, both at home and abroad. nevertheless, there is fairly broad consensus as to the merits of a market - based system and free cross - border capital movements. the frequency of financial crises must be reduced by fostering solid financial enterprises. risk systems must be improved. market access to information on developments in micro and macro performance must be enhanced in order to strengthen market discipline in the financial industry. better and uniform standards for accounting and statistics are important. financial safety nets may offer greater security to households and small enterprises, which have difficulty obtaining an adequate overview of the risks in the financial system. at the same time, however, they must not be so favourable that they encourage irresponsible risk2 bordo, m., eichengreen b.,