jean - paul redouin : risks may be transferred, but they do not disappear! address by mr jean - paul redouin, deputy governor of the bank of france, at the paris europlace, financial forum, stockholm, 29 march 2007. * * * the international financial system is going through an extraordinarily benign phase. the world is enjoying stable inflation and strong and broad - based gdp growth. at the macrofinancial level, corporate profits have been sustained, risk premia have been very thin for a broad set of asset classes, and volatilities remain unusually low. based on these market signals, risks appear very low. do risk premia correctly reflect the risks currently facing the financial system? or is their low level the result of excessive risk appetite on financial markets? indeed, some recent warning signals have reminded us how fragile the current pricing of risk is, and how much it relies on the expectation that an “ ideal scenario ” of strong growth and contained inflation will prevail. in this context, i would like to focus my remarks on a very important structural development : credit risk transfer. basically, the transfer of risks helps to spread them, according to a process i shall call the “ atomisation of risk " ( namely risk being split into elementary particles and then re - packaged ). but do these techniques mean that risks disappear? the breakthrough of crt has gone hand in hand with constant innovation and the emergence of powerful non - bank players. the financial markets are therefore in a state of permanent revolution in which globalisation and disintermediation have made the channels risk can take more complex and affected its traceability. this evolution can bring stability and resilience to the system only under certain conditions. the role of a central banker and supervisor is to list them, to inform the financial community of the systemic aspects of their development and to implement certain key policy measures. 1. crt can improve distribution of risk and stronger resilience to shocks. how? the first benefit is linked to a process of “ atomisation ” of risk. greater risk dispersion among investors may increase the resilience of the financial system in the event of shocks. financial engineering has enabled credit risk to be extracted from banks ’ balance sheets and broken down into portions of risk that are repackaged into portfolio products. this is the essence of securitisation mechanisms : the default of a large issuer has less chance of resulting in the default of its

creditors, and default losses are absorbed by a large number of investors. second, the emergence of powerful non - bank players to whom risk is transferred contributes to greater risk dispersion and market efficiency. one example is hedge funds, which have become large risk absorbers on credit markets. their share in derivative trading is estimated at up to 25 %. hedge funds trade mainly on the riskiest segments and often buy equity tranches of cdos, previously the preserve of banks. another example is institutional investors ( mutual funds and pension funds, insurance companies, etc. ), which have increased their exposure to risk transfer instruments, even though their investment policies remain fairly conservative. third, banks themselves may, via credit derivatives, improve their risk management. they diversify their risk profiles by gaining exposure to companies or sectors in which they do not have customer relationships and by hedging risks while retaining customer relationships. credit risk transfer mechanisms are also used by banks to deal with single - name concentration risk. consequently, major improvements in risk measurement have been made. from a prudential viewpoint, the basel ii framework takes better account of risk mitigation techniques employed by banks, including the use of credit risk derivatives, and applies specific treatment to securitisation. 2. but this evolution should make us more – not less – vigilant regarding the assessment and tracking of risks. the wider benefits that crt can bring should not give rise to a false sense of security. risks do not disappear as a consequence of their transfer. banks need to pay attention both to " residual risks " ( e. g. tail or extreme event risks ) and all of the risks ( e. g. operational risk, documentation and settlement risk, legal risk ) arising from the use of crt. furthermore, the growing complexity and volume of crt transactions call for enhanced monitoring. actually, understanding where risk ultimately lies and how risky exposures can build up is an essential prerequisite for safeguarding financial stability. the argument is fourfold : first, historically low interest rates and abundant liquidity have prompted an intense search for yield. lower interest rates have encouraged risk - taking and higher leverage as investors have wanted to secure high rates of return. a case in point is insurance companies, which have to service guaranteed rates of return, and pension funds that have agreed to specific benefits. as the return on risk free bonds has declined, investors have been increasingly led to search for yield and increase the share of risky assets, including