For some years before the turmoil erupted, we have been puzzled by how low risk was priced in most credit markets. Again, with slight exaggeration, the case can be made that mispricing of risk occurred because extreme events – i.e. tail risks – were systematically ignored. At a general level, complexity and opacity in the originate and distribute model made it difficult to understand the "true " nature of risk i.e. the probability distribution attached to specific instruments. More subtly, I wonder whether the slicing and tranching process – which gave rise to structured products – has, intentionally or not, both created additional tail risk and contributed to conceal it. Most managers, for instance, have been caught by surprise by the fast downgrading of AAA CDO tranches, which triggered massive write downs. With hindsight, we know that those tranches had lower average probability of default than the underlying loans – which provided the rationale for the AAA rating – but also possessed a much higher exposure to tail risk. That latest characteristic was not apparent from the rating. As a consequence, tail risk was clearly not priced in, which made those securities both very attractive and absolutely lethal. Tail risk was not only deeply concealed in the complex structure of the instrument. It was also, to some extent, "created" by the instrument itself. As a result of the tranching process, an underlying portfolio with normal risk distribution was transformed into a different set of instruments. Some (equity tranches) had a with very high average default probability.
The benefits in terms of increased transparency and better risk management are very significant. Those same changes, however, may contribute to create new amplification mechanisms inside the financial system. This is referred to as a "procyclicality" issue, by which we usually mean the tendency of financial system to accentuate fluctuations in real and financial variables around their trend. But amplification can also create persistence if the system is path dependant. We may thus have to broaden our definition of procyclicality, looking not only at fluctuations around a trend but also at changes in the trend itself, which would move the equilibrium of markets and prices and potentially create extreme events. A very subtle question arises, which would deserve both theoretical and empirical investigation in this context: when do cyclical fluctuations degenerate into a more fundamental and permanent deviation and what could be done to prevent it? Rating By essence, the rating process is discontinuous. Changes in ratings therefore create non linear effects in the dynamics of financial markets. Those effects are stronger when there are a limited number of rating agencies with the same behaviour and methodologies. For that reason, we need to consider whether both our supervisory processes and market practices do not rely too much on rating. Such "hardwiring" of ratings in our financial infrastructure may amplify small and localised discontinuities, thus creating the possibility for more extreme events. 2  BIS Review 151/2008  Understanding the current crisis Arguably, one major problem underpinning the current crisis is the pricing of risk.