individuals, circumstances differ hugely. young people starting out in the housing market probably always will borrow a large proportion of the price of their first house, and a large amount relative to their current income. such loans are risky for the individual borrower if bis central bankers ’ speeches something goes badly wrong. but for a well - managed bank ( and for the economy as a whole ) higher risk loans like those will typically be balanced with other loans which have gradually been being repaid for 20 or 30 years. for whole economies, “ too much ” debt can cause problems. but researchers are not really sure quite what is “ too much ” ( among other things, measurement and institutional differences complicate things ). historically, a much better indicator to watch out for has been large increases in debt ( relative to incomes ) for several years in succession. as reinhart and rogoff have documented, financial crises are often followed by tough economic times. but even without a financial crisis, periods of rapid increases in debt tend to be followed by periods of economic stress – recessions that last longer and prove more troublesome than a “ plain vanilla ” recession, in which any lost output is recovered very quickly ( new zealand ’ s mild 1998 recession might have been an example of that sort of recession ). there are good reasons why a large and rapid increase in debt ( to gdp ) seems to matter. debt is not taken on in a vacuum. people are readier to take on debt when they are relatively more optimistic than usual about the future. banks are keener than usual to lend when times feel good. and people make choices, re - organise their balance sheets and their spending patterns on the basis of that heightened optimism. any number of factors, often at least a couple in combination, can result in a credit boom getting started. countries ’ experiences differ on that score, even in the most recent boom. but, typically, something causes spirits to lift, and with them spending and business activity. people become more willing to take the risk of buying a house or farm, of consuming more of their incomes than previously, or of expanding a business. once credit is growing rapidly, the process tends, for a time at least, to be self - reinforcing. easy credit tends to lift asset prices ( strengthening expectations of further price increases ), and people feel wealthier as a result. experience tends to confirm people ’ s initial heightened sense of optimism. expectations of future incomes are revised up and people make

grant spencer : prudential lessons from the global financial crisis presentation by mr grant spencer, deputy governor of the reserve bank of new zealand, to the financial institutions of nz 2012 remuneration forum, auckland, 3 may 2012. * * * new zealand has a small open economy and a financial system that is well integrated into the international financial system. so, not surprisingly, new zealand was heavily affected by the global financial crisis ( gfc ) and the global recession that followed. in the real economy, our export prices tumbled and gdp growth remained negative or flat through most of 2008 – 2009. in the banking system, while we saw no failures, the banks were unable to access funding from the international markets for a number of months. this was alleviated through reserve bank liquidity support and government guarantees. in the non - bank sector of course, we saw a string of finance company failures. these were related more to the domestic property sector downturn and weak internal governance than international developments. however, increasing investor caution and competition for funding in the wake of the gfc did increase the funding pressures on finance companies. the gfc has taught us many lessons and it will continue to do so as we witness the follow - on effects of the original shock. today i want to talk about three key lessons from the gfc that i regard as the most important for prudential policy in new zealand. indeed i believe they are very relevant for all countries with well developed banking systems. the three lessons are : 1. the contagion effects of a crisis can be heavily amplified by the contraction of liquidity in funding and asset markets. 2. the credit cycle is a major driver of risk in the financial system – the seeds of crises are often sewn in the credit booms that precede them. 3. large bank failures can have devastating effects on both financial systems and government finances. governments must find ways of protecting the financial system from bank failures without having to resort to bail - outs. i will look at these three lessons in turn, considering the broad international responses we have seen, and looking specifically at what we are doing here in new zealand. the net result of all this is a raft of changes aimed at strengthening our existing prudential regime for banks, which we believe will enhance the soundness of new zealand ’ s financial system going forward. 1. heightened contagion and liquidity risk in the gfc, the first round of credit losses was seen in institutions holding us sub