of the key judgements are, first, what prescribed stress scenarios are appropriate inputs ; and second, what thresholds for satisfying these stress - tests are set. both are fiendishly difficult. on the first, a stress scenario is just one point in a probability distribution. which point to choose – indeed, which distribution to choose – is a matter of judgement. consider the two distributions for uk gdp growth shown in chart 6, one taken from the ten years to 2007, the other across a longer 150 - year sample. 2 the standard deviations of these two distributions differ by a factor of 4. 5. for a financial firm that is 30 - times leveraged, that can easily be the see haldane ( 2009a ), “ why banks failed the stress test ”. see www. bankofengland. co. uk / publications / speeches / 2009 / speech374. pdf difference between landing in the red rather than the black. in that sense, stress tests are not something it is possible definitively to “ pass ” – though experience suggests they are somewhat easier to “ fail ”. on thresholds, determining the optimal level of capital for a bank is an area which has been chronically, and perhaps surprisingly, under - researched. policymakers have repeatedly ducked this question. aggregate amounts of capital in the financial system have been fixed at the same levels which prevailed at the time of the first basel accord. and academics have, to my knowledge, no definitive quantitative answer to the optimal capital question. longer runs of data, while interesting, are far from definitive. over the past 150 years, capital ratios among us commercial banks have fallen roughly by a factor of ten ( chart 7 ). is the optimal capital ratio to be found from experience in the 1990s – roughly, 5 %? or from the interwar years – roughly 10 %? or from the latter half of the 19th century – between 20 % and 40 %? answering those questions will mean reassessing the validity of the modigliani / miller ( mm ) theorem in today ’ s capital markets. 3 mm states that firms ’ debt / equity ratios are essentially irrelevant to their total cost of capital. why? because a rise in leverage generates offsetting movements in the cost and risk of banks ’ capital, in a frictionless world leaving the riskadjusted cost of capital unchanged. by revealed preference, owners and managers of banks have rejected the mm hypothesis. they seem to perceive that raising equity is,

economic agents base their decisions on expectations of the future then the way monetary policy is expected to be conducted in the future affects economic outcomes today. hence it is very important to think about how policy influences the expectations of the private sector. consider a simple and stark example. suppose that a central bank managed to control inflation perfectly by responding to all shocks instantaneously. the outcome would be a constant inflation rate. households and firms would know that potential movements in inflation would never emerge because all future shocks would be instantly offset by changes in interest rates. interest rates would change with no apparent link to or effect on inflation. to an observer – whether journalist or econometrician – interest rate changes would appear to have little to do with inflation. the central bank would appear to be behaving almost randomly. but that inference would be false. indeed, if people did expect the central bank to behave randomly, then the behaviour of households and firms would change and inflation would no longer be stable. this is what i call the maradona theory of interest rates. the great argentine footballer, diego maradona, is not usually associated with the theory of monetary policy. but his performance against england in the world cup in mexico city in june 1986 when he scored twice is a perfect illustration of my point. maradona ’ s first “ hand of god ” goal was an exercise of the old “ mystery and mystique ” approach to central banking. his action was unexpected, time - inconsistent and against the rules. he was lucky to get away with it. his second goal, however, was an example of the power of expectations in the modern theory of interest rates. maradona ran 60 yards from inside his own half beating five players before placing the ball in the english goal. the truly remarkable thing, however, is that, maradona ran virtually in a straight line. how can you beat five players by running in a straight line? the answer is that the english defenders reacted to what they expected maradona to do. because they expected maradona to move either left or right, he was able to go straight on. monetary policy works in a similar way. market interest rates react to what the central bank is expected to do. in recent years the bank of england and other central banks have experienced periods in which they have been able to influence the path of the economy without making large moves in official interest rates. they headed in a straight line for their goals. how was that possible