Public disclosure requirements designed to compensate for this information problem do not exist. Even if information on the overall size of the fund’s positions were available periodically, it would be difficult to accurately ascertain its risk profile. This gives individual firms an incentive to free-ride on the due diligence or monitoring by others, which may render resultant collective discipline inadequate. The foundations of modern risk measurement rest on a framework that uses past returns to measure or estimate the distribution of future returns. The stability of the recent past, even if much of it proves durable, probably understates potential risk. The parameters used to estimate value at risk can produce very large differences in predicted exposure, especially at extreme confidence intervals. Estimating the potential interactions among these exposures in conditions of stress is even harder, due to the uncertainty about the behavior of investors and other market participants and because of the potential effects of financial distress on overall economic activity. The relatively short history of returns for new products, the complexity of measuring exposure in many new instruments and limitations on transparency also create the potential for classic “agency” problems - internal conflicts of interest that can lead to problematic outcomes. In exposures where the  4  BIS Review 85/2006  measurement of potential loss is more uncertain, more subjective, and less amenable to independent evaluation, for example, reasonable people can come to very different judgments about the potential risk in a particular position.

Today, only a few central banks, including Fed Reserve is still responsible for bank supervision. Others have handed this job to a separate agency. In the 1960’s the conventional economic wisdom was that monetary policy could reduce unemployment and directly promote economic growth. The theoretical basis for this was provided by the famous Phillips curve, which depicted an inverse relationship between inflation and unemployment in Britain; when unemployment was high inflation was low and vice versa. This appeared to have suggested that central banks could permanently reduce unemployment by tolerating a bit more inflation. In fact, many countries attempted to do so. We all have our experience in attempting to directly promote economic activities by releasing high powered money through various credit schemes and direct involvement in development activities. However, at the end we had more inflation, either visible or hidden, without an appreciable reduction in unemployment or improvement in growth. In fact, the rate of inflation associated with a given level of unemployment had risen through the 1970’s and policy makers had to abandon the Philip curve. This in fact was predicted by Milton Friedman and Edmund Phelps who challenged the Phillip curve. As they pointed out, the trade off between inflation and unemployment was only short term. As soon as people come to expect higher inflation they would demand higher wages, and unemployment would rise again . There is no trade off between inflation and unemployment. In the long run, monetary policy  BIS Review 52/2007  1  could influence only inflation.