glenn stevens : recent financial developments address by mr glenn stevens, governor of the reserve bank of australia, to aci2010 49th world congress, sydney, 26 march 2010. * * * welcome back to sydney. the last time that this body met here was in 1992. at that time the australian economy was in the early phase of a recovery from a deep recession. pessimism about the future was deeply rooted. the financial system was under considerable strain. unemployment was in double digits and still rising. inflation had fallen significantly, but many people thought this was a temporary impact of the downturn. they thought that if we did get a recovery – and some despaired of that – we would return to our old bad habits of high inflation. people worried a lot about australia ’ s substantial current account deficit. there were relatively few optimists. you might notice some of that sort of thinking today, in some other countries. i imagine that among the participants of that 1992 meeting one could have gotten some pretty long odds against australia having a long upswing, with inflation averaging “ two point something ”, surviving the financial crisis and ensuing global downturn with one of the mildest domestic downturns we have seen, and facing the future with a fair degree of confidence. this shows how hard it is to forecast, of course. but perhaps it also demonstrates that with time, effort, discipline, good policies and a bit of luck, economies can be returned to health and their citizens to prosperity. financial market recovery to that end, it is helpful that the global financial system is gradually recovering its poise, after a near - death experience eighteen months ago. perhaps like a patient that has suffered an acute cardiac event, there has been some lasting tissue damage, but quick intervention avoided something much worse. a period of emergency life - support has been followed by a period of recuperation, with some ongoing medication, during which the patient has been able gradually to resume normal activities. certainly the functioning of money markets has improved substantially. extreme counterparty risk aversion has abated and spreads of libor rates to equivalent maturity ois rates have come down to about the lowest levels since mid 2007. the dramatic expansion in the balance sheets of central banks in major economies has largely ended, though policy interest rates remain at 50 - year lows. australia ’ s situation is more advanced in this regard. the expansion in the rba ’ s balance sheet was unwound nearly a year ago and the

have unintended business - cycle effects. the safety net - - particularly deposit insurance and access to the discount window - - clearly has an impact beyond the stability it brings by containing the deposit runs that once led to financial implosion. it induces intermediaries to take on more risk with less capital, creating what is arguably the largest problem facing modern bank supervisors - - wide swings in credit quality. even without government rules, however, cyclicality still would exist in financial markets, the real economy, and in the actions of financial intermediaries. cyclical financial volatility, for example, was significant from the civil war to world war i, a period that - - abstracting from some of the perverse currency rules that came from the banking act of 1863 - - was not characterized by substantial regulation and rulemaking. moreover, behavioral factors, even if there were no rules or regulations, would still be a formidable force in inducing cyclical changes in both the quantity and the quality of assets acquired and issued in the financial sector. the most basic is human response to risk. the often - repeated pattern in financial markets has been the periodic shift in risk attitudes, initiated by the state of the economy, among lenders and other asset holders. history instructs us that, during recoveries and booms, risk discounts erode as the level of optimism lowers the barriers to prudence. even those lenders less inclined to reach for more risk - laden proposals are driven to maintain their share of the rising credit flow, if not to increase it. the only way bankers can adhere to lending policies significantly more stringent than those of their competitors is to effectively exit significant areas of banking, pending, in their judgment, the return of sanity to banking practices. such an approach, however, is not consistent with a viable long - term banking franchise. to the majority of banks, the environment of contagious optimism makes more and more proposals seem bankable. ever less attention is paid to potential problems as the cautious voices appear curiously quaint and have little quantitative support because all the recent news and facts are favorable. even the supervisors and policymakers tend to be caught up by the process. their voices of caution are rarely raised because they, too, find it difficult to make a case for restraint because the quantitative indicators do not support caution until too late in the lending expansion. as cyclical imbalances inevitably develop, the typical pattern has been an evaporation of optimism among