fragile banking system. so how did banks find themselves in such a precarious position? banks are a vital part of our economy. they run the payment system, allowing us to pay our bills and receive our wages. they finance businesses investing in new ventures and families buying a new home. without a banking system our economy would grind to a halt. because of that, markets correctly believed that no government could let a bank fail since that would cause immense disruption to the economy. this meant that large banks in particular benefited from an implicit taxpayer guarantee, enabling them to borrow cheaply to finance their lending. in good times, banks took the benefits for their employees and shareholders, while in bad times the taxpayer bore the costs. for the banks, it was a case of heads i win, tails you – the taxpayer – lose. this cheap funding fuelled lending. banks got bigger. in the uk, their balance sheets rose from around one - half to more than five times our national income in a generation. as the banks got bigger, so did the implicit subsidy – by the time of the crisis it reached many billions of pounds a year. the bigger banks became, the more they were seen as too important to fail, and the surer markets became that the taxpayer would bail them out. but there are only so many good loans and investments to be made. in order to expand, banks made increasingly risky investments. to make matters worse, they started making huge bets with each other on whether loans that had already been made would be repaid. the seeds of the eventual downfall of the financial system had been sown. as loans and investments went bad, those seeds started to sprout. in august 2007 came the moment when financial markets began to realise that the emperor had no clothes. the announcement by the french bank bnp paribas that it would suspend repayments from two of its investment funds triggered a loss of confidence and a freezing of some capital markets. a month later, the crisis claimed its first victim when northern rock failed. in the months that followed, there was a steady procession of banking failures culminating in the collapse of the american bank lehman brothers in september 2008. financial waters, already extremely chilly, then froze solid. banks found it almost impossible to finance themselves because no - one knew which banks were safe and which weren ’ t. from the start of the crisis, central banks provided emergency loans but these amounted to little more than holding a sheet in front of the emperor to conceal

meeting that morning with the chancellor, gordon brown, who had explained the proposal for bank independence. it was something for which eddie and i had worked for five years since britain ’ s departure from the exchange rate mechanism in 1992. now we had a chance to show what an independent central bank could do. although far from clear at the time, the later decision to remove from the bank of england the power to regulate banks would return to haunt us. over the next decade, the new monetary policy committee established a track record of low and remarkably stable inflation. in my first speech as governor in 2003, i warned that this stability was unlikely to continue. and it didn ’ t. within a few years, and despite low inflation, the advanced economies of the world were plunged into a financial crisis which led to the sharpest decline in world trade since the 1930s, recessions across the world, rising unemployment and the near collapse of our banking system. bis central bankers ’ speeches so tonight i want to try to answer three questions. first, what went wrong? second, what are the lessons? third, what needs to change? let me start by pointing out what did not go wrong. in the five years before the onset of the crisis, across the industrialised world growth was steady and both unemployment and inflation were low and stable. whether in this country, the united states or europe, there was no unsustainable boom like that seen in the 1980s ; this was a bust without a boom. so what was the problem? in a nutshell, our banking and financial system overextended itself. that left it fragile and vulnerable to a sudden loss of confidence. the most obvious symptom was that banks were lending too much. strikingly, most of that increase in lending wasn ’ t to families or businesses, but to other parts of the financial system. to finance this, banks were borrowing large amounts themselves. and this was their achilles ’ heel. by the end of 2006, some banks had borrowed as much as £50 for every pound provided by their own shareholders. so even a small piece of bad news about the value of its assets would wipe out much of a bank ’ s capital, and leave depositors scurrying for the door. what made the situation worse was that the fortunes of banks had become closely tied together through transactions in complex and obscure financial instruments. so it was difficult to know which banks were safe and which weren ’ t. the result was an increasingly