The forces behind all this are complex and not well understood, and this complicates any judgment of how enduring they will prove to be. The main candidates in terms of fundamental explanations involve change in economic conditions and in the structure of financial markets. There has been a marked improvement in global economic performance, with strong growth, relatively low inflation, and less volatility in both growth and inflation. This seems to have reduced concern about future fundamental risk, in terms of the potential damage of future shocks and in the ability of governments and central banks to both avoid the policy errors of the past and to competently manage some daunting longer-term policy challenges. The global trend toward independent central banks with clearer mandates for price stability has contributed to this confidence, as has the improvement in national balance sheets in emerging markets, with stronger fiscal positions, higher reserves, and less exposure to foreign-currency denominated debt. Changes in financial markets, including those that are the subject of your conference, have improved the efficiency of financial intermediation and improved our confidence in the ability of markets to absorb stress. In financial systems around the world, the capital positions of banks have improved and capital markets are becoming deeper and playing a larger role in financial intermediation. Financial innovation has improved the capacity to measure and manage risk. Risk is spread more broadly across countries and institutions. Technological change and the relaxation of controls have made it possible for capital to move more freely across national borders.

Leveraged arbitrage activity, so some of the literature suggests, is likely to reduce volatility in normal times and increase it in times of stress, because of the greater financial constraints faced by leveraged funds relative to larger, more diversified banks and  2  BIS Review 49/2007  investment banks. Whether this matters in a systemic sense or not depends on the heterogeneity of funds and how correlated their exposures are with those of the major banks and investment banks. A third reason is the consequence of long periods of low losses and low volatility. When markets have been through a sustained period of relative stability and low credit losses, this reduces the estimates of potential losses produced by conventional risk management tools. Like gravity, this force is hard to counteract. And when we’ve had a long period of low realized losses, rapid change in markets, dramatic growth in new instruments, and larger potential leverage, this creates a greater possibility of unanticipated losses, and therefore a greater potential for the trend amplifying, positive feedback effects that have characterized the major asset price shocks of 1987 and 1998. Policymakers do not have the capacity to eliminate the risk of excess leverage or asset price misalignments, nor do we have the ability to act preemptively to diffuse them. And yet policy can play a very important role in limiting the vulnerability of financial markets to the risk that a shock will pose greater potential risks to the stability of the financial system and to economic growth.