The infrastructure to support credit default swaps, the building blocks of many of these new products, is developing rapidly thanks to the initiative of the FSA and the New York Fed but there is still some way to go. Competition between financial firms to establish positions in these new and fast growing markets is also rising. The business risk not just of losing profits this year but of being left behind in the longer term by competitors looms large at the moment. And compensation structures that strongly reward financial performance are also influencing risk-taking. 4 There is a tendency for rewards from generating “excess returns” to far outstrip the penalties for poor performance. This intensifies the need to stay ahead of, or keep up with, the pack and stretches risk management systems in the process. The more aggressively management pursues short term shareholder value in the form of rates of return on equity, the greater the motivation to build leverage to meet its targets. Balance sheets have been growing strongly (Chart 5). In markets where a 20% return on capital is seen as disappointing, we are seeing efforts to emulate the business models of others and take on more risk through both proprietary trading (in fairly liquid markets) and principal position taking (in illiquid investments). The history of financial crises is replete with injudicious attempts to “keep up with the Joneses”.
It is shorter, more selective and clearer on what we think is important and what isn’t. Of course it is not difficult to draw up a long list of possible “triggers” for changes in sentiment in markets. Avian flu or worsening strife in the Middle East are two obvious ones at the moment. What we have tried to do in the new FSR is to identify the features of the economy and the structure of financial markets which could lead an initial shock to turn into a crisis. We set out six main sources of vulnerability. Two of these vulnerabilities are features of the global economy: unusually low premia for bearing risk and the large financial imbalances among major economies. Two relate to the balance sheets of the non-financial sector: rapid leveraging of some parts of the corporate sector and high UK household debt. And two arise from structural dependencies within the financial system: the rising systemic importance of large complex financial institutions (or LCFIs for short) and the heavy dependence of financial institutions on some elements of market infrastructure. In each case the probability of the risk materialising is small but non negligible.