of the banking system was necessary, was the centrepiece of the uk plan ( alongside a temporary guarantee of some wholesale funding instruments and provision of central bank liquidity ), and was in turn followed by other european countries and the united states. securitised mortgages – that is collections of mortgages bundled together and sold as securities, including the now infamous us sub - prime mortgages – had been marketed during a period of rising house prices and low interest rates which had masked the riskiness of the underlying loans. by securitising mortgages on such a scale, banks transformed the liquidity of their lending book. they also financed it by short - term wholesale borrowing. but in the light of rising defaults and falling house prices – first in the united states and then elsewhere – investors reassessed the risks inherent in these securities. perceived as riskier, their values fell and demand for securitisations dwindled. for the same reason, the value of banks ’ mortgage books declined. banks saw the value of their assets fall while their liabilities remained unchanged. the effect was magnified by the very high levels of borrowing relative to capital ( or leverage ) with which many banks were operating, and the fact that banks had purchased significant quantities of securitised and more complex financial instruments from each other. not only were these assets difficult to value, but the distribution of losses across the financial system was uncertain. banks ’ share prices fell. capital was squeezed. markets were sending a clear message to banks around the world : they did not have enough capital. at the annual meetings of the imf and world bank in washington ten days ago, the message was reinforced by our colleagues from japan, sweden and finland, who, with eloquence and not a little passion, reminded those present of their experience in dealing with a systemic banking failure in the 1990s. recapitalise and do it now was the lesson. recapitalisation requires a fiscal response, and that can be done only by governments. confidence in the banking system had eroded as the weakness of the capital position became more widely appreciated. but it took a crisis caused by the failure of lehman brothers to trigger the coordinated government plan to recapitalise the system. it would be a mistake, however, to think that had lehman brothers not failed, a crisis would have been averted. the underlying cause of inadequate capital would eventually have provoked a crisis of one kind or another somewhere else. so where

does this leave us? the recapitalisation plan is having a major impact on the restoration of market confidence in banks. perhaps the single most important diagnostic statistic is the credit default swap premium – an indicator of market concerns about solvency of banks. these premia have fallen markedly since the announcement of the uk plan. from the close of business on 7 october to now the premia on the uk ’ s five largest banks have more than halved. we are far from the end of the road back to stability, but the plan to recapitalise our banking system, both here and abroad, will i believe come to be seen as the moment in the banking crisis of the past year when we turned the corner. as concerns about the viability of our banks recede, banks should regain the confidence of the market as recipients of funding. there are already some signs of greater activity. but the age of innocence – when banks lent to each other unsecured for three months or longer at only a small premium to expected policy rates – will not quickly, if ever, return. in itself that does not affect the ability of banks to fund lending, but confidence has been badly shaken after the traumatic events of the past few weeks. new sources of funding will develop only slowly, although the temporary government guarantees of new lending to banks will help. so it will take time before the recapitalisation leads to a resumption of normal levels of lending by the banking system to the real economy. and we cannot assume that there will not be problems in other parts of the financial system and in some emerging market economies to be overcome before the crisis can truly be described as over. with the plan for recapitalisation in place, the focus of attention has moved to the outlook for the uk and world economies. over the past month, the economic news has probably been the worst in such a short period for a very considerable time. the most recent activity indicators for the second of half of the year have fallen sharply. in the uk, unemployment continues to rise and, over the past three months, has risen at the fastest rate for seventeen years, albeit from a relatively low level. house prices declined by about 5 % in the third quarter and are 13 % lower than a year ago. the recent weakness of the housing market is likely to continue. and if the news on the domestic front were not sufficiently discouraging, the rest of the world economy also appears to be slowing rapidly.