improved our confidence in the ability of markets to absorb stress. in financial systems around the world, the capital positions of banks have improved and capital markets are becoming deeper and playing a larger role in financial intermediation. financial innovation has improved the capacity to measure and manage risk. risk is spread more broadly across countries and institutions. technological change and the relaxation of controls have made it possible for capital to move more freely across national borders. and the characteristic reluctance of savers to invest outside their home market may be diminishing. alongside these longer terms trends, financial markets today also show the effects of other forces. the extraordinary growth in earnings of energy and commodity exporters, the substantial rise in wealth that has come with rapid growth in china, india, and other emerging markets, together with efforts by many of those governments to stem the appreciation of their currencies, has led to a rise in capital flows, official and private, into the united states and other major economies. these flows seem large enough to have had a material effect on global interest rates and asset prices. these changes in economic conditions reinforce each other. the long period of relative economic and financial stability has reinforced expectations of future stability, reducing implied volatility and risk premia, increasing comfort with higher leverage, and encouraging flows of capital into riskier assets. the low level of real interest rates that has prevailed in much of the world through this expansion has contributed to relatively accommodative financial conditions. the high levels of reserve accumulation by governments with heavily managed exchange rate regimes put downward pressure on forward interest rates, potentially distorting asset prices. the increase in size of sovereign wealth funds, the shift in assets to hedge fund and private equity managers, and the possible reduction in home bias among private savers have increased the amount of mobile capital in search of higher returns. the resilience of the market in the face of the latest shocks has increased confidence in future financial resilience. in these conditions, market participants face more acutely the classic dilemma of deciding whether to follow the market, or to buy more insurance against the risk of a reversal at the expense of near term returns. this mix of forces operating on financial conditions presents challenges for policymakers and financial markets participants, for it makes it harder to figure out what is fundamental and enduring and what is temporary or transitional, or the result of policy distortions. confidence exists alongside concerns about sustainability. although there is much that is positive in the world today, there is

1980s and early 1990s, jerry corrigan wrote that these same changes in financial markets we see today, though less pronounced then than now, created the possibility that financial shocks would be less frequent, but in some contexts they could be more damaging. this judgment, that systemic financial crises are less probable, but, in the event they occur could be harder to manage, should be the principal preoccupation of market participants and policymakers today. what factors might contribute to this risk, a risk that could be described as the possibility of longer, fatter tails? one reason is a consequence of consolidation. the major banks are larger and stronger today, and it would take a much larger shock to make them vulnerable than was true in the past. but in that event, the consequence of their failure could be greater for markets. another reason is the consequence of leverage. leveraged arbitrage activity, so some of the literature suggests, is likely to reduce volatility in normal times and increase it in times of stress, because of the greater financial constraints faced by leveraged funds relative to larger, more diversified banks and investment banks. whether this matters in a systemic sense or not depends on the heterogeneity of funds and how correlated their exposures are with those of the major banks and investment banks. a third reason is the consequence of long periods of low losses and low volatility. when markets have been through a sustained period of relative stability and low credit losses, this reduces the estimates of potential losses produced by conventional risk management tools. like gravity, this force is hard to counteract. and when we ’ ve had a long period of low realized losses, rapid change in markets, dramatic growth in new instruments, and larger potential leverage, this creates a greater possibility of unanticipated losses, and therefore a greater potential for the trend amplifying, positive feedback effects that have characterized the major asset price shocks of 1987 and 1998. policymakers do not have the capacity to eliminate the risk of excess leverage or asset price misalignments, nor do we have the ability to act preemptively to diffuse them. and yet policy can play a very important role in limiting the vulnerability of financial markets to the risk that a shock will pose greater potential risks to the stability of the financial system and to economic growth. a few points about both monetary policy and supervision in this context. it is now the consensus of most practicing central bankers that monetary policy can ’ t do much