The first, and most obvious one, is between the robustness and resilience of the financial system, on the one hand, and its profitability, on the other. With hindsight, it may be that parts of the returns achieved by the financial industry in the last decade have resulted from too big a tolerance of tail risk. Conversely, one can theoretically increase, almost to a maximum, the resilience of the financial system to extreme events by piling up strong liquidity and capital cushions in all its components. Of course, since capital and liquidity are costly, the economic viability of such a system would be open to question. BIS Review 151/2008  3  A second trade-off appears between risk sensitiveness and financial volatility. We are increasingly expecting our prudential and accounting regimes to reflect precisely, at any moment in time, the level of risk embedded in every financial instrument. This does make sense: prudential requirements, in particular, should be tailored to the risk attached to specific activities. But financial systems are naturally procyclical. Risk – and risk appetite – move up and down with the economic cycle. It is an open question then, whether financial regulation does or not contribute to creating additional feedback loops in an already complex system, thus reinforcing the probability of extreme events. Finally a trade-off appears between financial innovation and product standardization. Many economic activities are exposed to extreme risk, which (almost) never materialise.
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.