forms in which liquidity risk can arise. that requires both a careful analysis of the various potential sources of liquidity risk, and of how such risks may crystallise under stressed market conditions. as outlined earlier, in today ’ s financial environment, it is not just the simple maturity transformation between deposits and loans that generates liquidity risk for banks. to this must be added contingent risks, such as the potential activation of liquidity lines to off - balance sheet vehicles, or the drawing of committed facilities extended to corporate customers. contingent risks may also arise, in a variety of forms, from complex trading instruments, as detailed well by the institute for international finance ( iif ) last year. 5 yet more sources of potential funding pressure have emerged from greater activity in capital markets, such as the pipeline risk that arises from being unable to offload leveraged loans and warehouses of loans awaiting securitisation when unfavourable market conditions prevail. and banks are also subject to the risk of exposures previously passed on to third parties flowing back to them, for example when sub - prime residential mortgage - backed securities are “ put back ” to the originator should they be found to breach certain credit criteria. finally, banks are also exposed to the risks of a decline in asset market liquidity and falls in market prices through the potential for higher collateral or margin requirements. these may substantially raise the level of funding a bank requires on a day - today basis. institute for international finance : “ principles of liquidity risk management ” march 2007. as emphasised in a recent report by the senior supervisors group, 6 banks need to develop a comprehensive approach to the management of liquidity risk to ensure that it is in line with the bank ’ s overall risk appetite. one strong recommendation in the report is that financial organisations develop and apply a systematic policy of internal charging for liquidity risk. in particular, banks need to ensure that risk decisions made by front office traders price appropriately the liquidity risk generated by new products and business lines, rather than treating it as a “ free good ” or overhead to be managed centrally by the treasury function. furthermore, banks and supervisors should analyse in far greater depth how the wide range of liquidity risks may crystallise, separately or conjointly, in a stressed market environment. rigorous stress testing should span individual, group - wide and market - wide scenarios. there is considerable scope for much better consideration of likely system - wide interactions, including the potential impact

has exposed domestic producers to intense competitive pressures, but it has been unambiguously good news for consumers. and it has probably meant that the mpc has been able to set somewhat lower interest rates to meet its inflation target. the establishment of global markets in key asset classes has created complex linkages between economies as well as facilitating better risk sharing. on the one hand, the transmission of shocks has been speeded up – a generation ago, for example, who would have supposed that devaluation in thailand would have set off a chain reaction that rippled through financial markets from new york to tokyo? on the other hand, the absorptive capacity of financial markets has massively increased. this has helped to cushion the impact of major shocks on the wider economy. but it has also facilitated the financing of huge current account imbalances. these have been the number one issue on the imf ’ s worry list for the past few years and now constitute a significant source of risk to the world economic outlook. so you might expect the mpc ’ s policy rate to respond to changes in the world economic outlook, though you might speculate that the relationship could be quite complex. what does recent experience show? between 2000 and 2004, there was, on the face of it, a very close relationship between fluctuations in world gdp and the policy rate ; as all main regions of the world slowed after the stock market crash and the ending of the it boom, the mpc first cut its policy rate sharply – and then held it down until the world economy had clearly turned the corner in the second half of 2003. but it would be quite wrong to infer that the mpc ignored domestic demand during this period – though the data have now been so heavily revised it is difficult to generalise about past decisions. the important point is that the mpc ’ s approach then, as now, is to form an overall judgement about demand relative to supply and, as far as it can, to set the policy rate to keep the two in balance, so 1 / 3 that inflationary pressure is broadly constant. so with external demand very weak – and recall that by the end of 2001 world imports were actually falling – the logic of that approach pointed to leasing policy to encourage a faster growth in domestic demand. this approach worked well in the sense that it helped to ensure that the uk went on growing steadily through the world slowdown, while consumer price inflation remained close to the chancellor ’ s target. but there were