For example, I have been clear that, in the long run, the growth of derivative markets and the development of new players like hedge funds should help to price risks better and spread them more widely, and thus make the financial system more resilient. However, there is no denying that financial markets are liable to overshoot. And it is particularly important to stay alive to this risk when new records are being set for leveraged bids, returns on equity and City bonuses. Over-optimism in the financial system can have costs not just for the consenting counterparties but more broadly across the economy. By talking to you individually, drawing the threads together with our own analysis and feeding back a dispassionate but informed assessment of what your actions and plans add up to, we hope we can inform your decisions and thus help to head off instability. Low volatility One of the main vulnerabilities on our league table is low risk premia in financial markets – that is, the low level of compensation that investors are demanding to hold risk. In my remaining remarks I want to offer some observations on a closely related and interconnected topic: the low level of volatility in a number of asset classes. My colleague Paul Tucker has recently commented on low historic volatility. [Charts 2 to 4] show how the volatility of asset returns has come down for equities, bonds, and exchange rates to low levels by modern standards.
But in case four months is too long to wait, I want to use my comments today to set out our assessment of prospects for financial stability as we near the end of 2006. Recent developments Our view remains that near-term risks to UK financial stability are low. That is mainly a reflection of the continuation of broadly benign macroeconomic conditions in the UK and globally A rebalancing in global sources of growth does appear to be under way - and we are watching developments in the US economy and movements in the US dollar closely – but overall the global economy remains strong. UK financial institutions profitability and capital levels have remained robust, providing them with a buffer against future disturbances. Financial markets have also demonstrated resilience over the past six months. Markets were turbulent at the time we were preparing the July FSR. It was unclear whether we were at the start of a significant correction. The subsequent rebound in asset prices, and declines in measures of volatility, showed that it was a pause not a sustained change in risk appetite. More recently, we have seen huge losses at the Amaranth hedge fund. These losses exceeded those of LTCM, yet markets facilitated a smooth wind down in positions. That is reassuring though some questions remain about the capacity of markets to handle such a disturbance if the macroeconomic backdrop and the balance sheets of major institutions were less rosy.