I don’t have any great ideas on how to address this, but it is a problem that needs to be fixed. •  Collateral and haircuts. When volatility rises and that leads to increased haircuts, the result can be a vicious cycle of forced asset sales, higher volatility and still higher haircuts. •  Compensation tied to short-term revenue generation, rather than long-term profitability over the cycle. This causes risk-takers to take on too much risk because they are compensated on the upside. This extends the boom. Incentives Incentives may be very important in determining whether we have a system that is dampening rather than amplifying. I think bad outcomes are not just about bad luck, they are also about bad incentives. The problem with incentives may be due to faulty compensation schemes, poor risk management or the fact that participants do not bear the full costs of their actions. One problem that we had in the U.S. banking system over the past year was a reluctance of banks to raise sufficient capital to be able to withstand bad states of nature. They didn’t want to do this because this might unnecessarily dilute their shareholders. As a result, many banks did not hold sufficient capital and market participants knew this. This led to tighter financial and credit conditions, which made the bad state of the world more likely. This is an example of both bad incentives and an amplifying mechanism.
The high degree of interconnectedness across the financial system has a number of implications. First, supervision must not just be vertical – firm by firm, or region by region, but also horizontal – looking broadly across banks, securities firms, markets and geographies. Second, this means that supervisory practices need to be revamped. They need to be coordinated and multi-disciplinary. I think the U.S. Treasury is right in proposing a systemic risk regulator as part of their regulatory reform plan. But, we shouldn’t kid ourselves about how difficult this will be to execute. You will need a flexible and dynamic governance process to be able to identify the important elements of systemic risk, to elevate those concerns to the appropriate level and then to act on those concerns in a timely manner. It will take the right people, with the right skill sets, operating in a system with the right culture and legal framework. I don’t believe creating this oversight process will be an easy task. Consider, for example, subprime lending. There were obvious excesses in terms of underwriting standards, product design and risk management. But addressing those issues during the boom would have required the supervisor to absorb attacks that reining in some of these practices would make it more difficult for some low- and moderate-income households to become homeowners for the first time. System dynamics In thinking about interconnectedness, we also need to focus on system dynamics. By system dynamics, I mean how the different parts of the system interact.