•  Concern that instrument complexity and transaction volume could overwhelm settlement systems. Post 2008, these issues sound all too familiar, of course. Of particular note, the report stated that: A major source of concern derives from the difficulties in pricing new instruments and the possibility that many new instruments appear to be, at least to some degree, underpriced, that is, that gross income from the transactions is insufficient, on average, to compensate fully for their inherent risks. Since it may be necessary to accumulate experience over a variety of circumstances and cyclical conditions in order for market participants fully to understand and assess all elements of risk, this problem may appear especially before the market for a new product has reached maturity. The recent financial crisis in many ways represented the realization of many of these concerns. Some observations: •  1  2  The crisis demonstrated how the combination of poor underwriting, financial engineering, and leverage could transform what had been viewed as relatively safe markets for US residential mortgages, magnify risks in those instruments through securitization and leverage, and transmit the risks around large parts of the globe. Recent innovations in international banking (Cross Report). BIS central bankers’ speeches  •  The speed at which liquidity deterioration, market dysfunction and financial institution distress set in was breathtaking – far faster than experienced in earlier crises.
Measures to raise both the quantity and quality of capital at the large, systemically important firms, known as G-SIFIs, such as Basel III and enhanced prudential standards, are aimed at reducing the probability of failure. The work on recovery and resolution planning, as set out in the Key Attributes for Effective Resolution Regimes, a new global standard published in 2011, aims at mitigating the cost of failure by developing the institutional arrangements and concrete plans to place a failing G-SIFI into resolution. These initiatives at the global level have been mirrored at the national level in many countries. I’d draw special attention to stress testing in its role in reducing the probability of failure and to resolution planning in reducing failure’s social cost, because both represent an important shift of focus for the supervisory community. Both processes focus attention on the far adverse tail of the probability distribution of outcomes for a firm. Technology, financial modeling, and risk management theory and practice have greatly expanded and enhanced the supervisors’ ability to analyze and address those severe adverse outcomes. Another part of the regulatory reform agenda addresses weaknesses in short-term funding markets. Efforts here include seeking to reduce the reliance on intraday credit in the tri-party repo market, to strengthen risk management in the repo and other short-term funding markets, and to make progress toward developing a collateral liquidation mechanism to prevent fire sales of collateral in distressed markets.