In addition to the complications that follow on from an institution being established in several countries, supervision and risk management are made more difficult by the banking group sometimes choosing to manage the risks on a functional basis and not in accordance with the bank’s forma organisation. For example, a bank with operations in several countries can choose to locate all of its credit management to one country and its liquidity management to another country. In general, this development strengthens financial stability. The capacity to identify, manage and reduce risks has increased. The institutions’ cross-border operations make them less dependent on how the economy of an individual country develops. However, at the same time a number of new possible problems arise, which must be prevented and managed by institutions and authorities. Risks and vulnerabilities may fall between different authorities’ or countries’ fields of responsibility and thereby may go unnoticed. Or, if they are noticed, territorial conflicts may arise, making it more difficult to implement the measures needed. It may also be unclear where the risks will end up. Bank supervision can ensure that the banks have sold certain risks, but it is not clear whether the buyers have the knowledge and financial strength to manage these risks. In the worst case scenario, the risk will return to the bank in a loss situation. The development I have described must be met with increased harmonisation of regulations and supervision, both between sectors and between countries.
The sub-prime mortgages in the United States are an example of how certain risks can be underestimated if they are sold on to others, perhaps with opaque contracts. The loss of trust in certain kinds of financial contract, in particular in relation to their liquidity, has reduced the incentive to finance such operations, giving rise to chain reactions in all the markets. In this case too, the alarm was raised some time ago. I recall, for instance, a Financial Times article at the end of January 2007, six months before the start of the turbulence, which quoted a comment made by the President of the ECB at Davos, namely that international markets were underestimating risks and had to prepare for a substantial adjustment in the prices of financial assets. The response of the market operators to these warnings, in particular from the other side of the Atlantic, was: “We’ll keep dancing until the music stops”. One should not interfere with the market mechanism or lean against asset prices. Financial innovation, also in mortgage  BIS Review 61/2008  1  markets, was a positive development as it allowed households, also the less well-off, to finance consumption and investment. Not everybody shared this position. As early as February 2005, Paul Volcker, former Chairman of the Federal Reserve had drawn attention to the imbalances in the US economy, ranging from the balance of payments deficit and the possible bubble in house prices to the excessive household indebtedness. In his view, a correction of these imbalances was inevitable.