Two aspects of legal certainty are particularly crucial: Contractual certainty One key element of a stable legal framework is contractual certainty. Systems of contract law that show respect for formal agreements help to drive down commercial risk and therefore to promote the efficient allocation of capital. And uncertainty as to the enforceability of contracts is likely to be particularly damaging to financial markets. Against this background, contracts are becoming longer and more complex as financial innovation continues apace: the documentation for a structured finance product can often run into several hundred pages, thus raising the important issue of “documentation” risk. Legal and regulatory stability Another key element is legal and regulatory stability. This is very important to the financial markets, where the ability to form complex plans with a degree of confidence as to the stability over time of external influences (such as legal rules) impacts directly on risk, price and, ultimately, the efficient allocation of capital. A stable planning environment is conducive to investment and, therefore, market growth. Examples of harmful consequences of ambiguities in legal/regulatory frameworks include uncertainty as to the extent and scope of regulatory obligations or sanctions, and uncertainty as to how old laws will apply to dynamic and fast-changing market practices. The Financial Markets Law Committee (FMLC) In recognition of this, a number of countries have established groups of experts to promote greater legal certainty in financial markets. In the UK, the Financial Markets Law Committee was established in 2002.

Systemic stress-testing As financial markets evolve and new vulnerabilities are exposed, it becomes increasingly important that both market participants and the public authorities improve their understanding and assessment of threats to financial stability, and take steps, where appropriate, to contain and lower them. The Bank of England has been active in the development of models to identify and assess potential sources of major vulnerability to the UK financial system 2 and is, with the Financial Services Authority, engaged in a dialogue with practitioners, both to understand better current approaches to measuring risks under stressed conditions and to encourage improvements and the sharing of best practice in stress testing techniques. Recent distress in the US sub-prime lending market, and the collapse of the hedge fund, Amaranth, have exposed weaknesses in risk management, including in the management of contingent, or offbalance sheet, exposures. Although developments in the sub-prime market of course continue to unfold, the impact on conditions in broader financial markets has to date been relatively contained. But, in a more severe stress scenario, perhaps in a more significant market such as corporate credit, or one in which several areas of vulnerability were exposed in combination, the impact could have more serious consequences for the financial system. This highlights the potential value of a more rigorous assessment of tail-end risks. In particular, stresstests by financial institutions should attempt to incorporate the behavioural responses of other firms which may have a substantial impact on market conditions.