imbalances, the growing dependence of banks on wholesale funding, and the risk that structured credit markets could seize up in a downturn. when we took that message to chief executives of banks in london and new york, they generally accepted the analysis and agreed that a correction was bound to come. however, almost to a man ( and they were all men ), they took comfort from the sophistication of their risk management systems and hedging strategies. they were confident they could ride out the storm. but as it turned out their systems were preparing them for a shower not for a hurricane. the limitations of their risk models were cruelly exposed in august 2007. one cfo remarked last year “ we were seeing things that were 25 - standard deviation moves, several days in a row ”, which in plain english means that according to their models, the outright impossible was happening on a daily basis. according to the value at risk ( var ) benchmark for example – which measures the amount an institution stands to lose on its portfolio given an abnormal movement in market prices – there shouldn ’ t have been a big problem but that was partly because recent experience grossly underestimated what the truly abnormal really was. updating these models to take account of the volatility in asset prices seen over the past 18 months suggests measured risk increases by a half and in some cases doubles ( chart 7 ). many of the models depended on relatively short runs of data – one year for many, ten years at most. so the long period of stability reduced the projected losses from a future downturn ( chart 8 ). but the problem goes deeper than just choosing the right sample period to estimate these var models. using a longer back - run of data to re - classify august 2007 as an extremely improbable 5 standard deviation event rather than an effectively impossible 25 standard deviation event rather misses the point. the longer the build up of imbalances went on, and the larger they became, the smaller the chance that the bubble could burst without a correction. the events of august 2007 were not a bolt from the blue, an unpredictable random disaster, but the culmination of several years of developments in financial markets but inadequate models are not the only reason for being wary of putting too much weight on risk management by individual firms. there is also the vital question of incentives. chuck prince, the ex - chief of citi, has been widely condemned for saying : “ as long as the music is

for example, banks might be required to invest a varying proportion of their assets in a war - chest of government bonds and highly liquid assets. or they could face varying constraints on the extent to which they are allowed to tap short - term wholesale funds. finally we could introduce restraints on the terms on which banks can lend money to households and companies. loan to income and loan to value ratios tend to rise in any credit boom as lending standards become lax and asset prices inflate. in theory, a ceiling on these ratios could have provided an effective brake on the excesses of the last boom. while this has obvious microeconomic disadvantages, the hong kong monetary authority showed how such an approach could work in practice in the 1990s : tightening the constraint on loan - tovalue ratios as their property market threatened to overheat. another possibility would be compulsory margin requirements on trading positions. i am clear that counter cyclical capital requirements are a large part of the answer but i would be inclined to keep a number of other options open too. having a large arsenal of policy instruments, which vary in their point of influence provides some welcome flexibility. it allows the policymaker to respond appropriately to a particular situation, rather than treating all shocks the same. for example, if problems are concentrated within the property market then caps on loan - to - income and loan - to - value ratios might be effective. if instead the problem lay in funding markets, with an unwarranted compression in risk premia, then the instruments of liquidity regulation would be more appropriate. who calls the shots? that leads on to the issue of who should have control over these policy instruments? the answer i think very much depends on the objective of policy and the way in which policy is set. clearly the application of the policy would be for the regulator. if policy is given the narrower goal of protecting the banks from the cycle and it proves possible to set clear rules in place ( for example a simple leverage ratio ) there would be no need for a further policy maker to be involved. however if policy is given the broader macroeconomic goals of stabilising credit – protecting the cycle from banks if you will – and judgement is required on the state of the cycle and whether and when to vary the rules, then it would be essential for the central bank to play a leading role, albeit in close consultation with the regulator. in my view that is the more likely outcome. conclusion one theme you may have noticed in these reflections is