This increases the possibility that some investors – and issuers, for that matter – misunderstand the riskiness of an instrument. As a consequence, expected return may not appropriately reflect the true risk. When the true risk of an instrument starts to reveal itself, sharp corrections in the market may follow. The recent subprime crisis is one example of how new and complex instruments can give rise to global financial turmoil. Problems stemming from over-optimistic price expectations for the US housing market have spread to investors and financial institutions all over the world. The wide dispersion of the financial turmoil took many of us by surprise. Not to mention where problems turned up; in German Landesbanken, in large investment banks and in Norwegian hydro-electricity-rich municipalities, to name but a few. 1  Ben S. Bernanke (2006): ”Opening remarks” at ”The new economic geography: Effects and policy implications”, A symposium sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, Wyoming. 2  Alan Greenspan (2007): ”The age of turbulence”, The Penguin Press, New York. 2  BIS Review 14/2008  One lesson from the current financial turmoil is that the expected advantages of securitisation have been somewhat exaggerated. Securitisation was believed to make markets deeper and more liquid and – most importantly – to provide continuous pricing. Recent events have shown that this is not necessarily true for all markets at all times. In times of distress and uncertainty, some financial market segments can cease to function.
It’s a world that presents us with enormous new possibilities, but also enormous new challenges.” 2 In my presentation here today I will, not surprisingly, take a central banker’s view and ponder the challenges this new world might raise for a central bank trying to achieve both financial and nominal stability. Financial stability The last decade or so, we have witnessed increased financial integration and competition across national borders. The unleashing of international competition in financial markets is a positive development. By spreading and diversifying risk, financial markets have become more efficient and stable. Deeper and more mature markets tend to be better equipped to deal with uncertainty and distress. We have also witnessed the forging of new and ever more complex financial instruments. Increasing the set of available financial instruments creates more complete markets. It enhances the opportunities for households and enterprises to decouple consumption and investment from current income. Investors can take on or load off risks in a more tailored fashion than before and actively manage their exposures and relocate risks to those best equipped to bear them. Yet, the flip side of increased financial integration and diversification is the potential for more widespread contagion if something goes wrong. Furthermore, rapid innovation and increased complexity can make it difficult to assess the real underlying risks of the new instruments. It takes time for borrowers and lenders to learn the true characteristics of new instruments.