years. but one challenge is that, as for the authorities, it is hard for individual firms to gauge the likely “ systemic impact ” of particular shocks, which takes into account macro and financial system interactions and feedback effects. indeed, in practice, banks often model the effect of even severe macroeconomic shocks as if they were occurring to the bank in isolation. they thus may assume that they have freedom to readjust their balance sheets and lending practices in the event of an adverse shock, without considering whether other banks may be trying to do the same thing and the effect that these behavioural responses may have cumulatively on market liquidity and on the economy as a whole. an important implication is that many firm - level stress tests may consequently underestimate the possible impact of adverse shocks. as i have highlighted, some of the potentially missing effects should be captured in the proposed suite of models. but the proposed enhanced “ top - down ” approach outlined above may still benefit from additional insights gained from closer dialogue and interaction with major financial firms on their likely reaction to episodes of stress. i consequently think there is merit in more formal comparison of “ top - down ” and “ bottom - up ” stress testing exercises, and of seeking ways of integrating the two into more formal “ systemic ” stress tests, where the authorities present an initial scenario to firms and then modify the scenario in the light of feedback on the potential response by firms in an iterative loop. this approach has recently been pioneered by the dutch central bank. 6 it potentially offers a useful way of improving knowledge of key system - wide interactions, and thus could provide a valuable supplement both to improved “ top - down ” approaches and to “ bottom - up ” stress tests which are naturally targeted more closely at the major risks facing individual firms given their balance sheets and positions. 16 to conclude, there is a major programme of inherently difficult and challenging modelling work ahead for the public authorities and for financial firms. but this is very important. development of a more coherent and consistent framework for the analysis of financial stability is a major prize. ultimately this should improve the understanding and pricing of risk and support better targeting of public policy, focused more closely on containing systemic risk and on the maintenance of the public good of systemic financial stability. de nederlandsche bank ( 2006 ), financial stability : is the dutch financial sector stress - resistant? quarterly bulletin, december.

has already been taken on board by households in their spending decisions, and how much adjustment is yet to come. the annual survey of households ’ financial positions carried out for the bank by nmg consulting 1 included some special questions on this topic and found that, while the majority of households expected to be affected in some way, less than half had so far responded by spending less, working longer hours or looking for a new job. that suggests there may be further adjustment to come. investment fell even more sharply than private consumption during the recession – down almost 20 % – as the higher cost and reduced availability of finance, coupled with sharply heightened uncertainty about economic prospects, led businesses to cancel or postpone see “ the financial position of british households : evidence from the 2010 nmg consulting survey ” by mette nielsen, silvia pezzini, kate reinold and richard williams, bank of england quarterly bulletin, winter 2010. investment projects. while the outlook remains highly uncertain, the improvement in both financial markets and in the real economy since mid - 2009 is likely to have contributed to the modest recovery seen in businesses ’ capital spending over the past year. and though continued tight credit conditions may restrain the investment spending of small and mediumsized enterprises, the bulk of capital expenditure is carried out by large businesses. they appear to be less credit - constrained and also have better access to the capital markets. moreover, despite the downturn, the corporate financial position appears to be relatively healthy. so the availability of finance is unlikely to be a major brake. rather investment spending is likely to be restrained by the juxtaposition of muted product demand and an overhang of spare capacity. for almost as long as i have been a member of the bank ’ s monetary policy committee, we have pointed to the need for a re - balancing of the composition of demand at some juncture, away from domestic demand and towards net exports. accompanying that re - balancing would be a re - orientation of the structure of activity away from businesses that predominantly meet domestic needs towards those producing internationally tradable goods and services. the substantial depreciation of sterling – down around a quarter since august 2007 – should facilitate that re - balancing by making it more profitable to produce for export or to compete against imports. for example, relative unit labour costs in the united kingdom are now more than 25 % lower than before the crisis. the contribution of net exports to the recovery had – at least until the very latest gdp release – been somewhat disappointing. net