Their assessment horizon may also be shorter than the social optimum. And, crucially, coordination failures may be a factor: users of a particular infrastructure, many of whom may compete in underlying markets, need to coordinate their actions if they are to influence decisions on the future strategy of the infrastructure provider. Investment in the reduction of operational risk will be one such decision. Difficulties in organising effective bargaining among users may leave them unable to coordinate, particularly in the face of differences in their information, expectations or preferences. Potential welfare-increasing actions may, therefore, not be carried out. These market failures may justify intervention by the public authorities: either via a continuous oversight or regulatory regime; via targeted intervention; or maybe even via public ownership, as is often the case in respect of large-value payment systems and sometimes with securities settlement systems. An alternative strategy when faced with a monopoly provider might be to promote (or even set up) alternative, competing suppliers, to improve market contestability while ensuring adequate interoperability and substitutability across systems. Of course, given the existence of network externalities and increasing returns to scale, the cost of this form of risk mitigation may well be higher than the cost of regulating a natural monopoly on an ongoing basis.
Systemic stress-testing As financial markets evolve and new vulnerabilities are exposed, it becomes increasingly important that both market participants and the public authorities improve their understanding and assessment of threats to financial stability, and take steps, where appropriate, to contain and lower them. The Bank of England has been active in the development of models to identify and assess potential sources of major vulnerability to the UK financial system 2 and is, with the Financial Services Authority, engaged in a dialogue with practitioners, both to understand better current approaches to measuring risks under stressed conditions and to encourage improvements and the sharing of best practice in stress testing techniques. Recent distress in the US sub-prime lending market, and the collapse of the hedge fund, Amaranth, have exposed weaknesses in risk management, including in the management of contingent, or offbalance sheet, exposures. Although developments in the sub-prime market of course continue to unfold, the impact on conditions in broader financial markets has to date been relatively contained. But, in a more severe stress scenario, perhaps in a more significant market such as corporate credit, or one in which several areas of vulnerability were exposed in combination, the impact could have more serious consequences for the financial system. This highlights the potential value of a more rigorous assessment of tail-end risks. In particular, stresstests by financial institutions should attempt to incorporate the behavioural responses of other firms which may have a substantial impact on market conditions.