are made about whether to buy or sell. in some instances, the price discovery process can break down and buyers and sellers are unable to discover any price at all – perhaps because of a lack of information or because of general uncertainty among market participants. i would suggest that this is fundamentally what has occurred in some financial markets over the past several months. this has certainly not been the case in all markets. for example, while equity markets in the united states have experienced greater price volatility in recent months, and credit spreads have widened these views are my own and do not necessarily reflect those of the federal reserve board or the federal reserve system as a whole. see, for example, the work of friedrich a. hayek, including " competition as a discovery procedure " in new studies in philosophy, politics, economics and the history of ideas. chicago : university of chicago press, 1978. in markets for highly - rated, traditional debt instruments, i believe this has been a function of reassessing risk rather than a broader failure of the price discovery process itself. moreover, investment - grade corporations faced little trouble in issuing traditional debt instruments during the market turbulence in august and did so in significant volumes. in some financial markets, however, the price discovery process appears to have actually broken down. in particular, i am referring to markets for structured credit products ( for example, collateralized loan obligations and collateralized debt obligations ) that are often complex and opaque, as well as instruments that are linked to these structured products, such as asset - backed commercial paper. why did the price discovery process fail in these markets but not in others? i would suggest that there are two principal related causes. first, some investors may not have done sufficient due diligence with regard to complex structured products. prior to the recent market disruptions, many buyers and sellers of complex structured products appear not to have demanded sufficient information from sellers, and simply accepted investment - grade ratings of these securities as a substitute for their own risk analysis. when the problems in the subprime mortgage market began to emerge and delinquencies on subprime mortgages in pools backing these securities exceeded rating agency estimates, subsequently resulting in a number of downgrades, investors lost confidence in the quality of these ratings, and hence the quality of the information they had about these instruments, and pulled back from markets for structured products across the board. a second, related factor contributing to the breakdown in price discovery is the recognition by investors of complexity and

##ised formula for calculating solvency requirements. the framework is calibrated to provide an incentive for firms to invest and develop more sophisticated risk management. this is to be welcomed and encouraged. but there are risks to manage as well. solvency ii ’ s use of internal models is broadly similar to that of the basel framework but in fact provides even greater scope to firms in their modelling, as basel set certain bis central bankers ’ speeches minimum correlation assumptions for models but solvency ii does not. there is clearly a strong incentive for insurance companies to optimise their use of capital under the directive and to do so through the adoption of models. this is perhaps stronger in the general insurance market than in the life market due to the anticipated relative strengthening of solvency standards. internal models are, however, subject to supervisory approval, and of course approval by the insurance company ’ s own board. to my mind it is important that the approval process doesn ’ t get bogged down in detail such as endless documentation reviews but stays focussed on the key drivers of the overall solvency calculation arising from the use of a model. regulators and industry spend a lot of time arguing about the detailed calibration of very specific risk factors under the solvency ii framework. but it is when the solvency requirements for different lines of business and different aspects of risk are combined that the overall solvency requirement can swing significantly as a result of the judgements that are made regarding correlation and diversification. if this is where the big swings in numbers can occur, it should be at the forefront of the regulatory approval process and above all in the challenge from insurance companies ’ boards. diversification is of course an inherent part of the insurance business model but as you are aware, the risk is that diversification in times of stress is more apparent than it is real. the assessment of correlation and the level of diversification that is recognised is not a matter for a black box or a theoretical formula. it is inherently a matter of expert judgement for an insurance company ’ s senior management and boards, not just its quants and risk team. it is right and proper that boards should be expected to challenge vigorously the amount of diversification benefit being claimed in internal models even if they don ’ t know the internal plumbing of copulas or correlation matrices. regulators should expect them to take a prudent and conservative approach and to ask challenging questions about how the models will hold up in times of stress. the third dimension of solvency ii