• Concurrent slowdown in every major economic region: world growth to slow to 3.3 per cent this year and 3.7 per cent next year.

• All major countries opt for the same policies of near zero interest rates and fiscal tightening.

• European countries face remarkably divergent growth paths next year: Germany above trend growth and Southern Europe in deep recession. Tensions will heighten further.

• World demand below potential output growth means rising unemployment — in some countries even higher than seen in the Great Depression.

• The economy will contract by 0.5 per cent this year, but grow by 1.3 per cent in 2013.

• Consumer price inflation will fall below the 2 per cent target by the end of 2012.

• Unemployment will peak at 8.6 per cent in 2013.

• We expect the cyclically adjusted current budget to be in surplus in 2016–17.

The production of this forecast is supported by the Institute's Corporate Members: Bank of England, HM Treasury, Mizuho Research Institute Ltd, the Office for National Statistics, Santander (UK) plc and by the members of the NiGEM users group.

Trust allows financial transactions to take place when contracts are incomplete and the cost of negotiating too great for the parties involved. Banking covers many different types of transactions in assets with different levels of incomplete contracts. Investment banks have traditionally dealt with assets with incomplete contracts and often traded on informal and opaque markets. The creation of new global banks combined know-how, capital and collateral to generate enormous growth in these markets. While global banks developed trust with counterparties in specific markets, the opacity combined with limited liability structures also created principal-agent problems. The scandals which emerged are a reflection of these agency problems and have left trust in the banks greatly diminished. If levels of trust remain so low, this will be consistent with ongoing bank vulnerability, less lending to finance risky but profitable investment projects, and consequently lower economic activity. Regulation can support private incentives to accept codes of conduct which enhance trust.

As background for this special issue of the Review, this article provides an overview of recent developments in financial structure in the major industrial countries using national flow of funds balance sheet data. We focus in particular on changes in the size and composition of the balance sheet for the major sectors — households, companies, general government, foreign and financial as well as banks and institutional investors separately. Two recent subperiods are distinguished, namely the ‘great moderation’ of high growth and low inflation from roughly 1997–2006 and then the crisis period 2007–10. We discern elements of convergence — notably in corporate leverage — but also some continuing contrasts — such as household debt — between market- and bank-dominated financial systems, while highlighting that short-run changes arising from the conjuncture may blur longer-term trends in financial structure. Looking ahead, the data highlight common challenges from public and household debt, albeit to an extent that varies markedly between countries. Bank deleveraging and recapitalisation appear slow, while a subsector including shadow banks continues to grow except in the US. There are contrasts between France and Italy on the one hand and Germany on the other which underline the vulnerability of the former in the ongoing Euro Area crisis.

The article connects two streams of recent research on the financial sector. The first is the regulation literature, which emphasises the central role of incentives in the financial sector. It points out that the challenge of financial sector regulation, highlighted by the global financial crisis, is to align private incentives with public interest without taxing or subsidising private risk-taking. The second stream of research relates to financial structures and examines the mix of financial institutions and financial markets in an economy. It finds that, as economies develop, services provided by financial markets become comparatively more important than those provided by banks. The article brings these two streams together, pointing out that — as financial systems develop from bank-based to market-based — a traditional regulatory approach that relies on banking ratios becomes less effective. There is thus a greater need for properly monitoring and addressing the underlying incentive weaknesses in market-based systems.

This paper looks at the urgent and ongoing need to change the business models of global systemically important banks — particularly those that dominate the OTC derivatives markets which carry massive counterparty risk via collateralisation practices. It explores the three main lessons of the financial crisis: too big to fail, excess leverage and conflicts of interest. While regulatory reforms have been plentiful, none have adequately addressed the main source of the problems which lie in the very nature of the business models of large interconnected banks.

Korea has been a forerunner in incorporating macroprudential policies to mitigate the vulnerabilities from currency crises that can turn into a more generalised liquidity crisis. This paper examines longer-term design issues for a more resilient and stable financial system that could be expected to complement the existing macroprudential measures in achieving a more stable financial system. In particular, the paper examines the rationale and mechanics of a new public financial institution, provisionally called the Exchange Stabilisation and Guarantee Corporation (ESGC) whose main role is to buy dollar forward positions from Korean exporting companies who wish to hedge the currency exposure from long-term export orders. The ESGC is intended to mitigate the risks arising from the reliance on the role of the banking sector in providing currency hedging services to exporters. Rapid growth of short-term foreign currency denominated debt has been the result of banks receiving forward dollar sales by exporters, and then hedging the long dollar position by borrowing short in dollars. A public institution that can buy dollars forward, but which is designed so that there is no need to hedge by taking short dollar debt, can mitigate the rapid increase in short-term dollar debt in booms.