While our responsibility is for the UK’s system, the pivotal position of London as a major international financial centre means that we have to take a wider view of global developments and can share that perspective with colleagues abroad. One way of reducing the probability and impact of the risks to the UK financial system is by helping the private sector to improve their identification and management of risks. We contribute to that by talking to market participants about their businesses and drawing those threads together with our economic analysis of financial markets and trends. This enables us to feed back to market participants the broader picture to inform their understanding and management of their own risks. 3  1  Thornton, H (1802), An enquiry into the nature and effects of paper credit of Great Britain (Chapter 7), page 121. 2  Allen, F & D Gale (2000), Comparing financial systems, MIT Press. 3  Bernanke (2006) also highlights risk management lapses by the private sector as a key source of crisis and stresses the vital role of market discipline in preventing such lapses from recurring. See Bernanke, B (2006), Hedge funds and systemic risk, remarks at the Federal Reserve Bank of Atlanta Financial Markets Conference, Sea Island, Georgia, 16 May. BIS Review 70/2006  1  In the latest edition of the Bank’s Financial Stability Report, we have sought to improve the way that we present our assessment of risks.
As more instruments that transfer risk are added to the balance sheets of financial institutions, so leverage and connectivity  2  BIS Review 70/2006  grow. While some of these connections might constitute a "perfect hedge", they can leave the system more vulnerable to both counterparty risk and the liquidity of these markets. The precise extent to which market participants are now connected through interlocking obligations is difficult to gauge, but the UK interbank market provides some clues. Over 70% of the total lending in the market is accounted for by 15 institutions. And the major UK banks’ large exposures to the main foreign-owned LCFIs are almost two-thirds of Tier 1 capital. The rising correlation between the share prices of major UK banks and foreign-owned LCFIs also provides a hint of the growing interconnections (Chart 4). At the same time, rapid innovation in new financial instruments poses challenges within the financial system. As I have already discussed, these developments are likely to be positive in the long run, allowing market participants greater scope to diversify and manage risk. But in the short run, newer products, such as structured credit derivatives, do pose challenges. We simply do not have experience of how they behave in the full range of market conditions. The models that have been built by banks and other players in the market to value and hedge positions in these instruments are more sophisticated than ever before, but they are not proven in adversity.