thomas j jordan : systemic risk and regulation – managing the challenges speech by mr thomas j jordan, vice chairman of the governing board of the swiss national bank, at the 5th annual meeting of the swiss finance institute, zurich, 3 november 2010. * * * i would like to thank dr. claudia strub, till ebner and dr. robert bichsel for their valuable support in drafting this speech. introduction the handling of systemic risk in financial systems is an immense challenge. first, because it is not always possible to pinpoint the precise sources of systemic risk due to complex interdependences in global financial markets. second, because before the outbreak of a crisis it is almost impossible to identify which domino will be the first to fall and thereby bear the ultimate responsibility for causing the financial system suddenly to falter and even collapse. finally, the impact of systemic risk can extend way beyond the system that is initially affected. when the financial system is close to collapse, the costs are enormous, as was clearly apparent in the latest financial and economic crisis. in my presentation today, i will talk to you about where we currently stand in our examination of the background to this latest crisis and how we can best address the diverse challenges in relation to systemic risk in the financial system. i will begin by explaining the issue of systemic risk in a little more detail, taking the recent crisis as my example, and making it clear why regulatory interventions in the financial system are necessary. on the basis of these explanations, i will then present the key criteria, which, in my opinion, should be used as guidelines when designing regulatory measures. in other words, i will be sketching the core components of a kind of roadmap for containing systemic risk. however, since we can never rule out the emergence of a new crisis, we also require a well - placed safety net. this will help to secure an adequate supply of liquidity to banks and markets, even at times of increased stress. a final section will be dedicated to this area, with some remarks on the importance of the central banks ’ function as lender of last resort. systemic risk and the financial crisis normally a number of different factors are simultaneously responsible for the accumulation of systemic risk over time leading to a crisis – as happened in the recent crisis. a number of well - known examples of possible risk factors and undesirable developments in the financial system include irrational market developments ( e. g. bubbles during the upswing or fire sales during

importance, their failure costs would be so high. thus, at present, tbtf financial institutions are not obliged to bear the full extent of the risk they assume. in the event of problems they can pass on the risk to the general public. this is a fundamental contradiction to the basic principles of a properly functioning market economy. in order to contain these market imperfections the guiding principle should be – do what is necessary, but no more than is necessary! consequently, the measures to be taken need to contribute to stability without obstructing key welfare - enhancing functions of the financial system. in particular, it is important that the measures are first and foremost designed to correct false incentives and to guide them in the right direction so that, first, unprofitable financial institutions leave the market of their own accord and, second, potential losses are borne by these institutions themselves, and not by the state. consequently, in my opinion, measures such as a ban on proprietary trading or the introduction of a narrow banking system, that intervene too strongly in banks ’ business models, are not very suitable. such measures neither target the objective nor are they in line with the basic principles of the market economy. with regard to the tbtf issue, this principle has prompted the committee of experts appointed by the swiss government to draw up proposals including the creation of incentives for banks to become less systemically important overall, thereby reducing potential costs for the economy. at the same time, the committee of experts ’ proposal will allow for improved resolution in the event that insolvency appears imminent, and this will significantly alleviate the tbtf problem. are the measures “ structural ”? a second criterion is that the measures should not just address the specific circumstances of the most recent crisis. in other words, fighting the last war will not win the next one. at the same time, the lessons of history show us that certain basic mechanisms repeat themselves in every crisis. consequently, it is very important that we recognise these general patterns and include them in regulatory considerations in order to improve our crisis prevention. this prevention is geared to establishing instruments whose effects are as broad - based as possible, in other words, instruments that are independent of the specific causes that lead to crises. one general pattern in financial crises is that market and investor confidence plays a central role. 2 in general, when a bubble is being formed, soaring price trends are initially explained in “ rational ” terms. in the recent crisis, for instance, developments in the us housing