Although this concept is attractive, there are still many concerns from a regulatory point of view. The Fair Value Option may be inappropriately used and may result in unreliable financial information. For example, when a bank applies the Fair Value Option to its liabilities and is downgraded, the yield for its liabilities will increase to reflect the increased risk. Consequently, the mark-to-market value will be lower than the original value, and the gain is recorded as profit. Therefore, it seems unreasonable that banks can record profit in a difficult period by applying the Fair Value Option to their own liabilities. Ladies and Gentlemen, My last point is that Basel II and IFRS will undeniably bring some fundamental changes to the business of banking. First, banks may need to rethink their operations and strategies on account of the expected greater involvement of third parties. The point here is that new regulations allow banks to use financial models to estimate required capital and fair values of assets and liabilities. This means banks can take advantage of the lower capital requirements by offering cheaper or more cost efficient products to their customers. However, to develop financial models requires a certain amount of data and know-how which a single bank may not have. So, to  BIS Review 114/2007  3  overcome this difficulty, banks may have to seek support for additional credit data from peer banks, rating agencies, or the credit bureau. Second, banks must increase their knowledge base regarding risk management techniques, especially on risk modeling.

It is well known that such systems can exhibit the following features: non linearity and discontinuities (a good example being liquidity freezes); path dependency; sensitivity to initial conditions. All this accounts for truly unpredictable behaviour. It creates uncertainty in the Knigthian sense: even with full knowledge of the "fundamentals" it may be impossible to associate a probability distribution to future states of nature. However, complexity creates the possibility of extreme events. It does not make them happen necessarily. Other factors may also contribute: one of them is human behaviour. 2. Financial systems are "human" systems. Their dynamic is shaped by the way human beings react to changes in their environment. Those reactions can help and amplify initial shocks to a point that a real "catastrophe" may occur. Herd behaviour has long been known as an essential feature of financial markets. More subtly, individual reactions, by themselves rational, can, by the virtue of their mutual interaction, produce strong amplification effects. This has been luminously shown by Danielsson and Shin in their seminal article on "endogenous risk", based on the now famous parable of the Millennium Bridge. Extreme events and modern finance With slight exaggeration, a case can be made that modern finance has been built, in practice, if not in theory, on implicit tolerance and widespread ignorance of extreme events. BIS Review 151/2008  1  The use of models Models are extensively used to assess risks and price assets. Nearly all models are based on the prevalence of "normal" (Gaussian) distribution as the basic tool.