. myth 4 – investment banks were not subject to runs, because their liabilities were collateralized there has long been an understanding, and indeed a regulatory presumption, that banks could be subject to “ runs, ” resulting in a need for both deposit insurance and a heavily regulated environment to reduce that risk. at the same time, it had largely been presumed that investment banks were better protected against such runs. while the balance sheets of investment banks had substantial short - term liabilities, many of them were collateralized. investment banks would buy longer - term securities but finance them with short - term borrowing ( using repurchase agreements ). it was assumed that because there was collateral backing up the loans, borrowers were protected and would not run. financing securities with short - term borrowing allowed investment banks to substantially expand their balance sheets, as shown in figure 10. however, the lenders in this market collateralized debt obligations ( cdos ) constructed from subprime asset - backed securities ( abs ) are perhaps the most potent example of underestimation of risk. triple - a rated cdos did more damage to balance sheets than triple - a rated abs. holding to maturity may have moderated some losses, but many did not have that luxury. investors needing to sell with the threat of downgrades suffered substantial losses, particularly in an illiquid environment. others have called the approach “ originate to hide. ” bis central bankers ’ speeches were other banks, money - market funds, and hedge funds. as questions about the value of the collateral became more prominent, and the solvency and liquidity of investment banks became a greater concern, many short - term lenders abandoned the market. figure 11 shows the dramatic change that occurred. the inability to finance large securities holdings made the traditional model of investment banking unsustainable, and this contributed to the failure of investment banks and the merger under duress, or conversion to bank holding companies, of others. what can we do about financial myths, going forward? we plumb this history to help us understand what we can do about financial myths, going forward, and how we can avoid their damaging impact. as the previous slides have shown, taking too much confidence in historical data repeating in the future can be dangerous – to the financial health of institutions and the financial system. that said, we are probably not likely to see a sea - change in the tendency for overconfidence in and reliance on recent statistical regularities. however

the federal reserve could drain the excess reserves from the banking system. we have a variety of tools. we could sell some of our long - term assets, thereby increasing longer - term interest rates. we now pay interest on reserves, and that rate could be increased to discourage bank lending. the size of our balance sheet, the composition of the balance sheet, and our short - term interest rate target are all instruments that we have available to reach our destination of full employment with stable prices. fundamentally, decisions about shrinking our balance sheet – like decisions to tighten interest rates – should be conditional on economic conditions. some analysts warn of rapid inflation arising from the expansion of the fed ’ s balance sheet ; but these forecasts have not been borne out. in fact, despite the buildup in excess reserves, the inflation rate has been falling – and i expect this trend to continue over the near term. the experience in both japan and the united states is that after a banking crisis, excess reserves have not been inflationary in the short term. of course, once the banks have recapitalized and economic resources are more fully utilized, we would not want to have a large stock of excess reserves. again, as noted, we have a variety of tools to remove excess reserves at a time when that becomes appropriate. as a result, i agree with many forecasters who expect disinflation in the near term. the substantial excess capacity in labor markets that i mentioned earlier has caused compensation to decline quite markedly ( see figure 11 ). because employee compensation is the main cost component for most companies, lower labor costs enable businesses to improve profit margins without substantial price increases – particularly as the demand for goods and services improves. this brings us back to yogi berra, who famously said, “ when you come to a fork in the road, take it. ” at times, a fork in the road is exactly what confronts monetary policymakers. we would face a fork, for example, if inflationary pressures were building despite a high unemployment rate. in this case, the choice between restraining inflation and supporting employment is a difficult one, and the policy decision becomes more complicated. however, with employment well below the level of full employment, and disinflation continuing to move us away from my own inflation target of 2 per cent, one does not currently need to make such trade - offs. another possible complication could occur if very low interest rates were causing excessive, leveraged bets that were inflating