address the various problems. capital ratios are being increased, and the quality of capital is being improved. maturity transformation is being reduced. and banks are holding more liquid assets. these changes are occurring not just because of new regulations, but also because they are being demanded by the marketplace. together, these various changes are increasing the cost of financial intermediation conducted across the balance sheets of banks. in effect, the choice that our societies are making – partly through our regulators – is to pay more for financial intermediation and, perhaps, to have less of it. the benefit that we hope to receive from paying this higher price is a safer and a more stable financial system. this choice has a number of related implications, and i would like to mention just a couple of these. bis central bankers ’ speeches the first concerns lending spreads and the return on bank equity. in particular, loan rates are likely to be higher relative to short - term money market rates than would otherwise have been the case ; in effect, some of the incidence of the higher cost of financial intermediation falls on the borrowers. in addition, if banks are safer, then, all else constant, some of the incidence of high cost of financial intermediation should also fall on the owners of bank equity who should be willing to accept lower returns. but, of course, the story does not stop here. lower returns on equity are likely to increase the incentive for bank management to take on new risks in an attempt to regain earlier rates of return. lower rates of return may also lead to renewed efforts at cost cutting. this could have some positive effects, but if it were to involve cuts to the risk - management function, cost cutting could create new risks. and finally, to the extent that investors realise that credit and other risks are higher than they had previously thought, they might want more compensation for holding bank equity despite the efforts to make banks safer. these various effects are quite complicated and they will take time to play out. the one change that we have already seen very clearly is a rise in loan rates relative to the cash rate. for example, during the 10 years prior to 2007, outstanding variable mortgage rates averaged 150 basis points above the cash rate. today, this difference is around 270 basis points. this increase is due partly to the global loss of trust in financial institutions, which has led to all banks paying more for funds in capital markets. it is also due to the strong competition for deposits domestically, with banks

inflation pressures. unemployment has been rising, and will probably rise a bit further yet ; growth in labour costs have slowed noticeably in response. indeed, growth of the wage price index is around the lowest in the 15 - year history of the measure. measures of unit labour cost growth are correspondingly quite low. so, absent continually rising profit margins on the part of businesses, we don ’ t see the conditions for persistently higher consumer price inflation, even though tradable goods prices are expected to rise due to the lower exchange rate. measures of inflation expectations remain wellanchored and are around or below their long - run averages. our view remains that the outlook for inflation, while a little higher than before, is still consistent with our medium - term target. trends in asset prices are an area to watch. in particular, we need to be alert to the possibility that the past year of strong rises in dwelling prices leads people to assume that this is the norm. were such an assumption to lead to increasing speculative activity, accompanied by a renewed increase in household leverage with all the associated risks to the housing market and the economy more generally, that would be unwelcome. this is a theme discussed in some detail in our latest financial stability review, released earlier bis central bankers ’ speeches today. we are watching this closely, and we remind people that house prices can go down as well as up. in fact there have been two episodes where prices fell for a year during the past decade. the australian prudential regulation authority will also be emphasising with lenders and their boards, as it has been for some time now, the need to maintain high lending standards. there is, of course, the full panoply of other “ risks ” that can be identified. as always, the exchange rate is a source of significant uncertainty. much of australia ’ s outlook also depends on developments overseas. further progress towards the full treatment of banking problems and the return to sustainable fiscal budgets in europe will be important. with greater certainty in the united states over their fiscal policies and the path of monetary policy, the risks there may now be more on the upside. on the other hand, if some event – like a geo - political shock – led to a wider retreat from risk taking, this could have a significant dampening impact on the global economy. china ’ s outlook is important for australia as, for that matter, it is for other countries. china is now the largest or second largest trade partner