, or adjustment, will produce destabilising spillovers in the financial system. on the first – the probability of adjustment – it is widely agreed by economists that one symptom of global imbalances, the us current account deficit, is unsustainable. it cannot continue indefinitely at the same rate because eventually the us ’ s external debt - servicing burden would become too great. that there will be adjustment, somehow or other, is therefore viewed by most commentators as near certain. by contrast, while the low risk premia across credit markets are hard to explain, no one can say for certain that they are unsustainable. a number of changes in the environment point towards some sustainable reduction in risk premia : more credible monetary regimes ; more flexible labour and product markets, helping economies to adjust to nasty shocks ; improved instruments and markets for managing risk ; better diversified portfolios. whether or not that merits the degree of risk premia the importance of communication to monetary policy was explored more fully in tucker p m w ( 2006a ), “ reflections on operating inflation targeting ”, speech at chicago graduate school of business, may 2006, bank of england quarterly bulletin, summer 2006, pp 212 - 224. compression seen over recent years is open to question. for some while now, i have encountered few people in the market who regard credit risk as fairly priced. a distinction is typically drawn – including in the bank ’ s financial stability reports 2 – between a “ fast fuse ” risk, in which credit is abruptly repriced ; and a “ slow fuse ” risk, in which cheap credit leads over time to overleveraged borrowers and so to vulnerability to a deterioration in the global economy. as time passes, attention has perhaps been shifting to the longer - fuse risk, given signs of a pick up in aggregate corporate sector leverage and gradual dilution of covenants in loan terms and conditions, most obviously recently in so - called “ covenant - lite ” transactions in the leveraged loan market. 3 but, in contrast to global imbalances, no one can say with complete conviction that a lower risk premia environment is definitely unsustainable, which may contribute to explaining why few market participants seem prepared to bet on the time or scale of any correction. in terms of the second dimension – the probability that any adjustment would be disorderly – market practitioners at least seem to regard “ low risk premia ” more seriously than “ global imbalances ”. resolution

- called greenspan ( or any other kind of ) “ put ” here ; the focus would be not asset prices, but the outlook for spending in the economy and so inflation. this is obviously rather different from a similarly nasty shock producing severe disorder in a banking system that was carrying unduly concentrated exposures of some kind. for a central banker, banks matter because their liabilities are used as money, they are at the centre of the payments system, and they carry an associated asset / liability maturity mismatch. 6 banking system distress is therefore typically characterised by a liquidity run. faced with that, a central bank ’ s instrument – used, where necessary, in collaboration with its regulatory and finance ministry partners – is to supply the system chaplin g, emblow a and michael i ( 2000 ), “ banking system liquidity : developments and issues ”, bank of england financial stability review, december 2000, pp 93 - 112. with an increased quantity of its money, without necessarily changing its price. given the need to take collateral to protect against risk, and to charge a premium to create the right incentives, establishing a routine framework for such operations without creating moral hazard remains “ work in progress ” for the international central banking community. 7 so it would seem that there is a good deal to welcome in the greater dispersion of risk made possible by modern instruments, markets and institutions. but there are most certainly qualifications to such an apparently alluring conclusion. b ) the banking system ’ s residual risk, stress testing and transparency the banking system retains risk in a number of ways, both pre - and post - risk transfer, and its aggregate balance sheet has in fact expanded considerably. 8 pre - risk transfer, banks and dealers hold, or finance, warehouses of portfolios of loans to households and corporates on their way to securitisation, 9 meaning that the banking system can still find itself “ holding the parcel ” when the music stops. post - risk transfer, some risk is contingently retained by virtue of banks and dealers financing the acquisition of risk by hedge funds and others. this entails counterparty credit risk and, taking account of collateral, is akin to writing out - of - the - money put options. so, for me, the question is not so much “ where is the risk? ”, as “ in what circumstances could risk flow back to the banking system? ” ; and “ do banks have enough capital and liquidity to absorb such flows without