Conclusion The changes in the financial system since 1998 confront us with a mix of benefits and challenges. The larger size and scope of the core institutions, the greater opportunities for risk transfer and hedging provided by innovation in derivatives, the improvements in risk management, the larger role played by a much expanded number and more diverse mix of private fund managers seem likely to have improved the stability and resilience of the financial system across a broader range of circumstances. The same factors that may have reduced the probability of future systemic events, however, may amplify the damage caused by and complicate the management of very severe financial shocks. The changes that have reduced the vulnerability of the system to smaller shocks may have increased the severity of the large ones. Supervisors need to continue to focus attention on reducing the vulnerability of the market to these low probability, but extreme events, while preserving the benefits that have come with these changes in financial markets. The limitations of the conventional risk-management tools in assessing potential losses in the adverse tail of possible outcomes in today’s financial system magnify the risk that individual institutions will operate with less of a cushion than might be desirable for the market as a whole. As the structure of markets change, we need to continue to review whether the overall framework of supervision over the core banks and investment banks provides the right balance of efficiency and resilience for the system as a whole.
In most circumstances, increased trading and participation contributes to market liquidity and makes markets less volatile. The ultimate benefit should be lower risks for all market participants. This in turn should reduce the risk premia associated with holding financial assets, and ultimately reduce the cost of capital. The rapid growth in the relative importance of these leveraged financial institutions has been accompanied by a number of structural changes as well. The total number of funds has grown dramatically. There are more very large hedge funds and private equity firms. Greater institutionalization, and the maturity of risk management and operational infrastructure in the largest of these private funds, has likely reduced operational risk. To the extent these changes have increased the diversity of firms and strategies in this part of the financial system, and this is hard to measure with any confidence, this heterogeneity should provide diversification opportunities, foster more efficient price discovery and could help improve stability. These changes in market participants have occurred in conjunction with a dramatic acceleration in number and type of derivative instruments. These developments have likely had the important impact of allowing for a more efficient distribution and more effective management of risk. All of these changes should move the market in the direction of fostering the efficient allocation of credit and capital formation, and thus enhancing the economy’s real growth potential.