deal with the imbalance between responsibilities and powers. the “ plumbing ” of the financial system represented by payment and settlement systems may not be as glamorous as the trading activity which attracts so many bright young people to work in the financial sector, but it is absolutely crucial to maintaining stability. to have responsibility without power is the misfortune of the bureaucrat. the solution, in my view, does not mean more powers for the bank, but narrower responsibilities. proposals are under active discussion among the tripartite partners, and they give me confidence that the imbalance will soon be resolved. financial stability more generally is a topical concern in financial markets. more than one banker and merchant in the city has said to me recently, “ i cannot recall a time when credit was more easily available ”. how worried should we be? let me begin with the implications for the stability of markets and institutions before turning to monetary policy. securitisation is transforming banking from the traditional model in which banks originate and retain credit risk on their balance sheets into a new model in which credit risk is distributed around a much wider range of investors. as a result, risks are no longer so concentrated in a small number of regulated institutions but are spread across the financial system. that is a positive development because it has reduced the market failure associated with traditional banking – the mismatch between illiquid assets and liquid liabilities – that led henry thornton and, later, walter bagehot to promote the role of the bank of england as the “ lender of last resort ” in a financial crisis. but the historical model is only a partial description of banking today. new and ever more complex financial instruments create different risks. exotic instruments are now issued for which the distribution of returns is considerably more complicated than that on the basic loans underlying them. a standard collateralised debt obligation divides the risk and return of a portfolio of bonds, or credit default swaps, into tranches. but what is known as a cdo - squared instrument invests in tranches of cdos. it has a distribution of returns which is highly sensitive to small changes in the correlations of underlying returns which we do not understand with any great precision. the risk of the entire return being wiped out can be much greater than on simpler instruments. higher returns come at the expense of higher risk. whether in banking, reinsurance or portfolio management, risk assessment is a matter of judgement as much as quantitative analysis. ever more complex instruments are designed almost

mervyn king : monetary policy developments speech by mr mervyn king, governor of the bank of england, at the lord mayor ’ s banquet for bankers and merchants of the city of london, london, 20 june 2007. * * * my lord mayor, mr chancellor, my lords, ministers, aldermen, mr recorder, sheriffs, ladies and gentlemen : chancellor, this will be your last mansion house dinner with the merchants and bankers. and i want to start by warmly congratulating you on your record - breaking period in office, and on the imminent assumption of the leadership of your party and country. it has been a remarkable decade for the british economy. your decision to grant independence to the bank of england ten years ago is widely and rightly regarded as a fundamental improvement to the conduct of economic policy in this country, and we in the bank are grateful to you for giving us the opportunity to demonstrate the benefits of an independent central bank. your reform illustrates the key principle that institutions matter. individuals, however talented, cannot consistently perform well if the institutional structure in which they operate is badly designed. for too long the uk economy lurched between success and failure rather in the way that the national cricket team has recently. getting the institutions right was a crucial part of the 1997 reforms. perhaps there is a lesson here for the ecb – the england and wales cricket board. and i welcome the changes that you announced last week to make appointments to the monetary policy committee subject to a more transparent process with a more systematic timetable. behind the design of our monetary institutions is a simple principle. i described it last october in a lecture at kirkcaldy. it is that the value of paper money depends on trust. trust that it will hold its value. trust that others will accept it as a means of payment. in particular, our banknotes must be trusted by the public – cash still accounts for over 60 % of the number of transactions. in march the bank launched a new series of bank notes with enhanced security features. as an economist, i was pleased that a pioneer of the dismal science should appear on our bank notes. adam smith, who appears on new £20 notes, was a thinker who recognised the importance of institutions. imagine my concern, therefore, when, after 3 ½ years as governor, i read the following report from the wolverhampton crown court. “ a judge demanded to know why police failed for three and a half years to arrest a wanted birmingham man – when all