than changing interest rates. indeed there are at least two situations where the use of capital controls and limits on gearing might not be a very effective means of maintaining financial stability, namely if either : 1. the link between an institution ’ s leverage and its robustness to real ( or imagined ) risks to the value of its assets were very weak..... or... 2. there were great sensitivity of the overall cost of funding to changes in equity capital – so that requiring an institution to hold much more capital came at a very high price. if either of these things were true it would strengthen the case for using monetary policy directly to help preserve financial stability. but i think there is strong evidence that neither of these things are very likely. the only reason why a financial firm ’ s leverage ( the ratio of assets to equity capital ) would be irrelevant to robustness is if that equity were not truly loss - absorbing or if it was already so large relative to assets that the chances of losses being that great becomes virtually zero. but in fact bank equity capital that is truly loss absorbing has been 10 % or less for most banks, and generally a great deal less. that is certainly not so high that chances of losses this big are of negligible probability. value - at - risk ( var ) models might have suggested otherwise. but those models have weaknesses that reflect the difficulty of accurately assessing risks. assessing the probabilities of losses on bank assets is not easy. many bank assets are not marketable – or only became so a few years before the crisis. and where prices do exist, using their recent volatility and assuming price changes follow a normal distribution is unlikely to be reliable. yet that is what most var models do ( or at least did ). we do have long runs of data on total incomes for economies – that is gdp. since the value of bank assets – most of which are loans – ultimately depends upon the incomes of households and companies, variability in gdp is at least some guide to variability in their true value. analysing changes in annual gdp for a large sample of countries over long periods reveals two characteristics : changes in annual gdp do not follow a normal distribution ( they have much bigger chances of extreme movements ) and the chances of big falls are much greater than the chances of big rises ( there is clear downwards skew ). the table below shows the proportion of occasions when annual gdp fell by various amounts in one year 3. the sample is

struck by a trivial example of where a bad equilibrium path can lead on a recent visit to the us. i opened the mini bar in my hotel room to find it empty save for a small slip of paper. here is what it said : “ a personal note to you.... we have made a renewing change to our heavenly guest rooms. our refreshment centers will no longer be pre - stocked. please be aware the refreshment center cooler is not intended as a refrigeration device ” the empty - mini - bar equilibrium is not a good one. how do you get there? i think the story is this : mini - bar prices are high ; they are high because some people conveniently tend to forget how much they may have used their mini - bar when they come to pay the bill and that forgetfulness gets worse the higher are prices ; but then the mini bar prices need to be even higher as the forgetfulness seems to get worse. this vicious cycle ends up with mini bars that are empty save for a “ personal note to you ”. good economic policies can help prevent bad equilibria and reduce the chances of vicious circles. for banks, i believe the most direct way to do this is to prevent an initial ( limited ) fall in the value of assets triggering sharply higher concerns about their solvency. it seems to me the natural way to do that is to make sure they can withstand falls in asset values by having sufficient loss - absorbing capital rather than to expect monetary policy – moves in interest rates – to substantially reduce asset price variability, much of which might be warranted. the short - term nominal interest rate is a very blunt instrument to use to try to limit gearing of financial institutions. capital requirements, and explicit limits on gearing, are more direct means to control leverage. this is why i think the direction of the policy emerging from the basel iii process – which will put in place higher capital requirements on banks – is right. it is also why time - varying limits on gearing of financial firms – limits that might vary with asset prices and with the economic cycle – are likely to be useful in helping maintain financial stability. i believe that is a much more fruitful way forward than abandoning inflation targeting. but while i think this is plausible, the case is not proved. simply because they are a more direct means to control leverage does not prove that capital requirements or limits to gearing are a far more effective tool to preserve financial stability