But what can policy makers do ex ante to limit the risk of crisis? The most powerful instruments we have are those that affect the strength of the basic, fundamental shock absorbers in the financial system. When capital and liquidity cushions at the major institutions are strong, then markets as a whole are less vulnerable to the adverse spiral of asset price declines, increased volatility, and declining liquidity. And when the operational infrastructure is robust, markets will be able to absorb larger shocks and sharper changes in risk appetite with less risk of broader contagion. These shock absorbers are substantially stronger today than they have been in even in the relatively recent past. These issues are the principal focus of day-to-day supervision and market oversight in the major financial centers around the world. The Federal Reserve is actively involved in a range of efforts, working closely with the primary supervisors of the major global financial institutions and the critical parts of the financial infrastructure, to encourage further progress. In this context, we are working to put in place a stronger regulatory capital regime and to strengthen the capacity of firms to absorb losses in stress conditions. We are encouraging more sophisticated and more conservative management of credit exposures in over-the-counter (OTC) derivatives and structured financial products, as well as of exposures to hedge funds. And we are encouraging a range of efforts to modernize the operational infrastructure that underpins the OTC derivatives markets, and to improve the capacity of market participants to manage adversity.

13  See, for example, Alessi and Detken (2009), “‘Real-time’ early warning indicators for costly asset price boom/bust cycles: a role for global liquidity”, ECB WP Series No 1039, March; Borio and Drehmann (2009), “Assessing the risk of banking crises – revisited“, BIS Quarterly Review, March; ECB Financial Stability Review, June 2009, Special Feature D “Estimating probabilities of hedge fund liquidation”. BIS Review 115/2009  5  Risk assessment Risk assessment relates to the evaluation of the relevance and potential severity of each risk identified as material in the surveillance phase. It should therefore include a quantitative evaluation of the likelihood that the potential risk scenarios could actually materialise, as well as an evaluation of the ability of the financial system to absorb the shocks (for example, through existing capital buffers or through the potential to increase buffers in the future through profit retention). It should also include cost estimates in terms of the failure of institutions, costs deriving from the malfunctioning of financial markets or impairment of the real economy. The product of these factors forms the basis for the ranking of risks. Quantitative methods and analytical tools (for example, macro-stress testing models) should support, together with expert judgement, the prioritising or ranking of these risks. The models will help in the conduct of quantitative impact assessments on the financial sector as well as in the assessment of the potential costs for the real economy, and thereby offer information about the relevance and severity of the risks detected in the surveillance phase.