jean - pierre landau : extreme events in finance – some reflexions remarks by mr jean - pierre landau, deputy governor of the bank of france, at the conference on extreme events jointly organised by the bank of france and the toulouse school of economics ( tse ), paris, 3 september 2008. updated on 23 november 2008. i want to thank benoit coeure and my colleagues laurent clerc, sylvie matherat, imene rahmouni, anne - marie rieu and pierre - francois weber for their comments and suggestions on earlier versions. * * * the current crisis is a strong reminder, if needed, that extreme events can occur inside the financial system. over the last year, we have witnessed many episodes ( 1 ) whose outcome can reasonably be defined as " catastrophic " and, ( 2 ) which could not have been predicted according to probability based on past experience. here, i would like to develop four points : are financial systems prone to extreme events? is this propensity aggravated by modern finance, as it evolved during the last decade? does this problematic help us understand the current crisis? and, finally, what are the possible policy responses? are financial systems prone to extreme events? i can see at least two reasons why this may be the case. 1. financial systems are complex systems. they are based on interdependence between multiple actors and counterparties. transmissions occur through networks whose structure and architecture is constantly transformed by financial innovation and regulatory arbitrage. this potentially creates numerous feedback loops. it is well known that such systems can exhibit the following features : non linearity and discontinuities ( a good example being liquidity freezes ) ; path dependency ; sensitivity to initial conditions. all this accounts for truly unpredictable behaviour. it creates uncertainty in the knigthian sense : even with full knowledge of the " fundamentals " it may be impossible to associate a probability distribution to future states of nature. however, complexity creates the possibility of extreme events. it does not make them happen necessarily. other factors may also contribute : one of them is human behaviour. 2. financial systems are " human " systems. their dynamic is shaped by the way human beings react to changes in their environment. those reactions can help and amplify initial shocks to a point that a real " catastrophe " may occur. herd behaviour has long been known as an essential feature of financial markets. more subtly, individual reactions, by themselves rational, can, by the virtue of

amplification can also create persistence if the system is path dependant. we may thus have to broaden our definition of procyclicality, looking not only at fluctuations around a trend but also at changes in the trend itself, which would move the equilibrium of markets and prices and potentially create extreme events. a very subtle question arises, which would deserve both theoretical and empirical investigation in this context : when do cyclical fluctuations degenerate into a more fundamental and permanent deviation and what could be done to prevent it? rating by essence, the rating process is discontinuous. changes in ratings therefore create non linear effects in the dynamics of financial markets. those effects are stronger when there are a limited number of rating agencies with the same behaviour and methodologies. for that reason, we need to consider whether both our supervisory processes and market practices do not rely too much on rating. such " hardwiring " of ratings in our financial infrastructure may amplify small and localised discontinuities, thus creating the possibility for more extreme events. understanding the current crisis arguably, one major problem underpinning the current crisis is the pricing of risk. for some years before the turmoil erupted, we have been puzzled by how low risk was priced in most credit markets. again, with slight exaggeration, the case can be made that mispricing of risk occurred because extreme events – i. e. tail risks – were systematically ignored. at a general level, complexity and opacity in the originate and distribute model made it difficult to understand the " true " nature of risk i. e. the probability distribution attached to specific instruments. more subtly, i wonder whether the slicing and tranching process – which gave rise to structured products – has, intentionally or not, both created additional tail risk and contributed to conceal it. most managers, for instance, have been caught by surprise by the fast downgrading of aaa cdo tranches, which triggered massive write downs. with hindsight, we know that those tranches had lower average probability of default than the underlying loans – which provided the rationale for the aaa rating – but also possessed a much higher exposure to tail risk. that latest characteristic was not apparent from the rating. as a consequence, tail risk was clearly not priced in, which made those securities both very attractive and absolutely lethal. tail risk was not only deeply concealed in the complex structure of the instrument. it was also, to some extent, " created " by