that are more suited to the banking system ’ s present situation — the current rules were formulated in the light of the financial situation in 1988. efforts are also being made to achieve a higher degree of transparency and clearer accountancy. the recurrent crises in financial markets unmistakably show that the work of reinforcing the system is a continuous process that must not be neglected. developments last autumn made it clear that the work the banks had already initiated to improve risk management did not suffice to prevent renewed financial turbulence. the pattern of risks differed somewhat from earlier periods with problems. instead of the familiar difficulties with the banks ’ loan portfolios, in large measure it was a matter of risks that certain highly leveraged players would generate problems through large positions in the repo market, for example. a drastic example — ltcm the problems in the u. s. hedge fund long term capital management can be seen as a drastic example of how systemic risks can arise if the banks ’ counterparty risks and concentration risks become unduly large. a single player, seemingly far removed from the payment system, threatened to generate a systemic crisis in the u. s. financial system, with the risks of contagion that this might involve. ltcm, which had been operating since 1994, based its strategy on the use of statistical and mathematical models to identify temporary price differentials between similar financial market assets. this involved speculating, for example, in narrowing interest rate spreads in the u. s. bond market. in simple terms, a limited capital input was used to combine forward purchases of u. s. corporate bonds with forward sales of u. s. federal bonds. the combination of countervailing positions meant that the outcome would not be affected by the general development of interest rates. it was only the relative paths of the two asset categories that mattered — a narrowing interest rate spread would result in a profit. similarly, the fund took large countervailing positions between different asset markets as well as between markets in different geographical regions. to begin with the strategy was notably successful ; high profits were obtained with a low capital input. in 1995 and 1996 the annual profit was over 40 per cent. this performance and the confidence that the fund management enjoyed made many banks willing to provide loans or invest in the fund. in time, however, the financial markets moved in the opposite direction to what ltcm — and others — had expected. russia ’ s debt moratorium on 17 august was followed by markedly increased

an average share portfolio is equivalent to around thirty times the annual earnings. the ratio in the united states is even higher, around 35 ( fig. 2 ). price - earnings ratio for sweden and usa affarsvarlden general index and s & p 500 s & p 500 average for 1871 - 1999 note : exceptionally high p / e ratios for sweden in 1992 and 1993 are not shown here sources : global financial data and statistics sweden although long series for the stockholm exchange ’ s p / e ratio are hard to find, it is hardly controversial to say that the present level is well above the historical average. the deviation of share prices from the fundamental conditions that have applied historically is even clearer after a look at the path of real trends in us shares s & p 500, average annual percentage change total real return real share price real earnings / share 1940 - 1981 1982 - 1999 note. averages calculated as geometric mean. somewhat different results may be obtained with an arithmetic mean, an estimated time trend or another base year, but the results still support the conclusion that the earnings trend in recent years is not markedly higher than for the entire post - world war two era. source : global financial data earnings. in the united states the real earnings trend since 1940 has been virtually constant between 2 % and 3 %, while - as i just mentioned - the real return on shares shows a trend break after 1982 ( fig. 3 ). 2 are present share prices fundamentally justifiable? i shall now use a simple model to examine whether the present level of share prices can be justified in fundamental terms. 3 simplifying somewhat, this model equates the value of a share with the present value of the future income the share is expected to generate. a valuation in p / e terms accordingly rests on the assumptions that are made about these future incomes - the future growth of the company ’ s earnings - and the factor by which these incomes are discounted - the stock market ’ s expected return. we can insert alternative values for these assumptions to find the combinations that might justify different p / e ratios ( fig. 4 ). it will be seen that a p / e ratio of 14 can be warranted if the expected real return is 6 % and the real growth of earnings averages 2. 5 %. these figures are all approximately in line with the historical trends. p / e ratios with different combinations of earnings growth & expected return earning earnin s growth % gs expected return % 4. 5 4. 0