And also what new in this crisis is the implicit linkage through reputation risk as noted earlier, that is, banks became obligated to rescue failing SIVs even when there were no explicit contractual obligations to do so. Against this background, what then can regulators do to address the interactions and the feedback problems. This is not going to be an easy task, but let me try to frame the discussion into a context. First, it is clear that systemic risk is endogenous. Risk is first encouraged by procyclicality and once the tipping point is reached, the interactions within the system takes over, turning financial fragility into systemic risk. From the current crisis, it is clear that the scope and intensity of systemic risk are related closely to three factors: (1) the collective behaviour of market participants that contributes to the positive feedback loops; (2) the underlying structure of markets and market practices which dictate the manner through which the interactions of feedbacks are propagated throughout the financial system; and (3) the authorities’ own responses. Therefore, to address the problem, we need to focus our efforts on all of the three areas. First, on the collective behaviour of market participants, the key objective must be to tame or dampen the positive feedbacks through right incentives and better regulation. For example, regulation to disallow capital reduction for credit risk transfer off-balance sheet could have discouraged the originate-to-distribute model.

The current global crisis, however, exposes another important dimension of systemic risk where interactions within the financial system, as opposed to interactions between the financial system and the macroeconomy, have played a critical role in amplifying the losses. As we know, back in 2007, losses associated with the subprime mortgage market were initially estimated to be in the order of $ 50 billion. Thereafter, the dynamic of the interactions within the financial system, driven by risk management practices of banks, the response to the funding liquidity constraint by market participants, and heightened concern about counterparty risk, resulted in a protracted period of market distress, the drying up of liquidity, and set the stage for a spiral of losses. As it turns out, writedowns and losses worldwide have grown enormously. And to an appreciable extent, this amplification of losses is related partly to the interactions and the feedbacks within the financial system. Therefore, compared to the “time-dimension” of risk associated with procyclicality through which credit risk is a major propagation channel, the current crisis shows that the dynamic of the interactions within the financial system can also be very damaging, particularly in the financial system that is large and complex. In the current crisis, the forces at work were the positive feedback loops and the interactions amongst them. The interactions operated through the propagation channels of joint exposures to common risk drivers and network linkages between the financial institutions. In general, the feedbacks within the financial system can be both positive (i.e. selfreinforcing) or negative (i.e. dampening).