It will be even worse, according to the banks advocating this level playing argument, if their national supervisor imposes capital or liquidity requirements that exceed the international standards. 14. Pillar 2 of the Basel Accord was of course introduced, at least in part, to do just this by enabling supervisors to make adjustments in minimum required levels of capital to reflect individual bank risk profiles, but even here we are met with “level playing field” arguments – complaints that other jurisdictions don’t use Pillar 2 to the same extent – or at all – and so we should not use Pillar 2 aggressively or else we will “damage” or “ham-string” our banks. But if this is the case, then if all banks seek to maximise their profits, by pushing down or “optimising” their capital and liquidity levels and taking on more risk – focused on the Basel standard as the ultimate benchmark – then do we not risk the standard actually encouraging a “race to the bottom”? Is it a race that may lead to higher profits or RoE for banks and their shareholders only in the short term? Is it a race that could create, in the longer term, serious problems for the safety and soundness of the banks concerned and financial vulnerabilities for society as a whole? 15. I don’t profess to know all the answers to the questions I have just raised. No matter what, there is a clear and indisputable need to enhance the resilience and robustness of the global financial system.
This suggests that the probability of such an event occurring would be no more than once in 300 years under even the very conservative assumptions. But the event had occurred within five years of LTCM’s birth. 7. It is natural, and indeed probably inevitable, that, in seeking to predict the probability of an event occurring, we tend to look to past experience. However, as we all dutifully warn investors when selling investment products, “past performance is no guarantee of future performance” and so we must stand ready to admit that there are fundamental limitations in our existing risk management tools. That is, the predictive powers of models are inherently restricted by historical experience. Where we encounter something new, such as innovative products or business model changes resulting in different forms of connectedness and creating different and new transmission channels, the models face significant difficulty in accurately estimating risk. Furthermore, even if one could find better models, any models must inevitably assume market behaviour remains constant to some degree, yet we know too well that uncertainty and panic may and do engender irrational or herd-like behaviour which a model struggles to accommodate. So, if the model’s findings can be “misguided”, too great a reliance on them, or too limited an understanding of what the model actually tells us, may result in a significant misjudgement of risk. 8. All of this prompts the question of how far we should reflect on the efficacy of our methods for assessing, measuring and managing risks in the financial system.