The benefits in terms of increased transparency and better risk management are very significant. Those same changes, however, may contribute to create new amplification mechanisms inside the financial system. This is referred to as a "procyclicality" issue, by which we usually mean the tendency of financial system to accentuate fluctuations in real and financial variables around their trend. But amplification can also create persistence if the system is path dependant. We may thus have to broaden our definition of procyclicality, looking not only at fluctuations around a trend but also at changes in the trend itself, which would move the equilibrium of markets and prices and potentially create extreme events. A very subtle question arises, which would deserve both theoretical and empirical investigation in this context: when do cyclical fluctuations degenerate into a more fundamental and permanent deviation and what could be done to prevent it? Rating By essence, the rating process is discontinuous. Changes in ratings therefore create non linear effects in the dynamics of financial markets. Those effects are stronger when there are a limited number of rating agencies with the same behaviour and methodologies. For that reason, we need to consider whether both our supervisory processes and market practices do not rely too much on rating. Such "hardwiring" of ratings in our financial infrastructure may amplify small and localised discontinuities, thus creating the possibility for more extreme events. 2  BIS Review 151/2008  Understanding the current crisis Arguably, one major problem underpinning the current crisis is the pricing of risk.

This means that abrupt changes in prices or risk have a very low probability. The fallacy of this assumption has been clearly shown by Mandelbrot for stock prices, and it has been further demonstrated in many recent (and non recent) episodes for other asset prices and risk premia. Examples of the use of normal distribution in financial modelling would include the following: •  The most frequently used tool for risk measurement (VaR) frequently ignores "fat tail" risks. Many VaR measures are calibrated according to the expected loss of a portfolio under normal circumstances. Models with "fat tail" distributions are available, but seldom used, due to lack of reliable data over a sufficient period of time. •  Implied volatilities are usually extracted from option pricing, based on normal distribution. They are then used as inputs into trading strategies and models. As a result, the assumption of normal distribution widely "contaminates" the pricing, risk assessment and investment strategies across a whole range of markets and instruments. •  Finally, the pricing of many structured products is based on historical correlations among asset prices, with the assumption that those correlations are stable and do represent the ordinary state of nature. On the contrary, experience has shown that those correlations can change radically during a crisis, frequently collapsing to one, and take price movements to the extreme ends of the probability distribution. Procyclicality Many changes have been introduced in recent years to accounting and capital regimes in order to make them more risk sensitive.