lucrative – in other words banking became boring. curiously, this period of boring banking coincided with a period of spectacular progress. the third phase, beginning the 1980s, saw the loosening of regulation yielding space for innovation and expansion. banking became, once again, exciting and high paying. much of the seeming success during this period, according to krugman, was an illusion ; and the business model of banking of this period had actually threatened the stability of the real sector. krugman ’ s surmise accordingly is that the bank street should be kept dull in order to keep the main street safe. 5. the boring banking thesis found an echo in other influential voices. in a speech last month that attracted wide notice, mervyn king, governor of the bank of england addressed the moral hazard issue : why were banks willing to take risks that proved so damaging to themselves and the rest of the economy? the problem, according to governor king, was that financial institutions became too important to be allowed to fail. his solution : restrict banking to its traditional “ utility ” function – performing basic retail financial intermediation of deposit taking and lending, and providing payment and settlement services ; and hive off the riskier financial services such as proprietary trading into a separate entity. in what has come quickly to be known as the “ utility and casino ” model, the “ utility ” will be heavily regulated and will enjoy implicit government guarantee while the “ casino ” will be left to the discipline of market forces. 6. closer home, another equally influential voice – dr. y. v. reddy, former governor of the reserve bank of india – weighed in on the issue. in his guhan memorial lecture last month, dr. reddy called for “ back to basics ” in banking and urged that banks must curb the tendency towards further financialization of deposits they mobilize and must focus instead on lending to real sectors of the economy, particularly agriculture and the small and medium industries, that have limited ability to tap the capital markets. 7. although neither governor king nor former governor reddy mentioned “ boring banking ”, in a sense both of them were calling for what can stylistically be interpreted as boring banking. 8. krugman ’ s thesis of “ boring banking ” is interesting, but also debatable. it raises several important questions. what were the ills of the banking system that caused the crisis? is making banking “ boring ” a necessary and sufficient cure to those ills? how do the several proposals on

the assessment of the prospects for the financial markets and for deriving some lessons. at the early stages of the crisis, when it was still contained to the us sub - prime mortgage markets, delinquency rates on us sub - prime mortgages increased markedly after mid - 2005, for two main reasons. first, the interest rate charged on sub - prime mortgages is initially much lower than for a standard mortgage, but it is typically reset to a much higher rate, usually after a two to three year period. second, high rates of house price inflation since the early 1990s had encouraged some households to borrow for house purchases with the intention of refinancing, or repaying the mortgage, before the reset date. once interest rates on these mortgages started to rise, and house prices began to moderate and subsequently to fall, many borrowers were unable to service their loans, sometimes even before the reset date if they had been aggressively betting on further house price increases. the developments in delinquency rates and house price inflation are shown in the charts on slide 5. what are the prospects for the sub - prime mortgage markets? recall that the typical fixedrate period for adjustable - rate mortgages is two to three years, after which they are reset and tied to one of a number of common indices, which are closely related to market interest rates. notwithstanding a slight decrease in these indices as of recently, an estimated usd 400 billion of sub - prime mortgages will face a reset in interest rates over the next two years. the surge in delinquency rates quickly translated into falling values of residential mortgagebacked securities ( rmbss ), especially those backed by the most recently originated vintages of loans. the values of such securities, and the indices of credit default swaps ( cdss ) on such securities, have mostly continued to deteriorate until today ( see chart on the left of slide 6 ) ; box 2 of the review examines these issues in detail. the fact that claims on the cash - flows generated by sub - prime mortgages were embedded in a broad array of structured credit products, often layered on top of one another, explains why the unexpectedly severe credit losses on the underlying us sub - prime mortgages and the risk of potential future credit losses had such widespread effects on the financial system. the announcement by some rating agencies in early july that they would downgrade many asset - backed securities ( abss ) and collateralised debt obligations ( cdos ) backed by