paul fisher : tail risks and contract design from a financial stability perspective speech by mr paul fisher, executive director for markets of the bank of england, at clare college, cambridge, 1 september 2011. * * * the paper is co - authored with patrik edsparr, visiting fellow, bank of england. the authors would like to thank ravi mattu ( pimco, newport beach ), morten hviid ( uea ) and colleagues at the bank of england for their comments on a draft of this paper. the views represented in this paper are those of the authors and should not be taken as the policy of the bank of england or to represent the views of any other person at the bank. the wider theme of this conference is about what we have learned from the recent crisis. there have been many lessons. some are not new but just a re - learning of old lore : “ banks need to hold adequate capital ” ; “ real - estate prices can fall dramatically ” ; “ financial institutions need to avoid excessive risk taking ”. the authorities are pursuing a long list of regulatory initiatives to address the externalities arising from risks in banks and markets, including dodd - frank in the us, the european market infrastructure regulation ( emir ) in europe, the independent commission on banking ( icb ) in the united kingdom and the various basel capital and liquidity rules internationally. and the financial stability board has taken on a role in co - ordinating much of the other international effort. academic research also has a large part to play in this process, in both identifying the issues and proposing or evaluating policy responses. a lot of discussion is taking place around disentangling different forms of complexity in the market place. for example, regulators are promoting more transparency around funding and legal entity structure within complex financial institutions. and there is also a growing body of work that is exploring clearing houses and exchanges as important structural vehicles to mitigate the increased inter - connectedness driven by the growth of derivatives1. the approach taken in this paper is to look at some of the details of how risk - taking is executed and the underlying market structures. these micro - foundations can have a profound impact on systemic stability beyond the normal consideration of formal regulations. in particular, we focus on one aspect of market structure : contracts where, because of a failure to take into account how the financial system as a whole operates, the true value of the contract is different from what it was intended to be – by at least one

the alternative is to spend a third of their income on rent? the payments on a mortgage of 4 times income, paid off over 30 years, at an interest rate of 7 % ( rather higher than the prevailing standard variable rate of about 4 % ) would cost the buyer a third of their income. with a 10 % deposit, that means they ’ d be buying a home worth 4. 5 times their income. in short, the high levels of both mortgage debt and house prices in this country are a reflection of the high cost of housing in general. they are not the result of an addiction to debt or of reckless mortgage lending. so britain doesn ’ t have a high level of consumer debt. it doesn ’ t have a debt - driven housing market. and as we ’ ve seen, it doesn ’ t have rapid growth of credit overall. debt strikes back isn ’ t yet screening again. but there are pockets of the galaxy where it may be. in the past year, outstanding car loans, credit card balances and personal loans have increased by 10 %. household incomes have risen by only 1. 5 % ( chart 8 ). on credit cards and personal loans, terms and conditions have become easier. the average advertised length of 0 % credit card balance transfers has doubled to close to 30 months ( chart 9 ). advertised interest rates on £10, 000 personal loans have fallen from 8 % to around 3. 8 % today, even though official interest rates have hardly changed ( chart 10 ). these are all classic signs of lenders thinking the risks are lower. department for communities and local government ( 2017 ) ‘ english housing survey, headline report 2015 - 16 ’ 2 march. https : / / www. gov. uk / government / uploads / system / uploads / attachment _ data / file / 595785 / 2015 - 16 _ ehs _ headline _ report. pdf the effective mortgage interest rate was last at 7 % in 2001. since then, a number of structural forces have probably pulled down the ‘ equilibrium ’ level of global and domestic real interest rates, making this a conservative calculation. see, for example, vlieghe ‘ debt, demographics and the distribution of income ’ http : / / www. bankofengland. co. uk / publications / pages / speeches / 2016 / 872. aspx this point was made back in 2012 by my colleague ben broadbent. see broadbent, b. ( 2012 ) ‘