weaknesses in risk management, including in the management of contingent, or offbalance sheet, exposures. although developments in the sub - prime market of course continue to unfold, the impact on conditions in broader financial markets has to date been relatively contained. but, in a more severe stress scenario, perhaps in a more significant market such as corporate credit, or one in which several areas of vulnerability were exposed in combination, the impact could have more serious consequences for the financial system. this highlights the potential value of a more rigorous assessment of tail - end risks. in particular, stresstests by financial institutions should attempt to incorporate the behavioural responses of other firms which may have a substantial impact on market conditions. for instance, scenarios should take account of the extent to which many firms might respond to a common shock in a similar way, with potential implications for market prices or market liquidity. the likely amplification of price moves as financial institutions attempt to exit “ crowded ” trades and liquidity dries up is an important example. indeed, given the importance of market liquidity for the efficient execution of banks ’ dynamic hedging strategies and for their activities in the wholesale funding and credit risk transfer ( crt ) and securitisation markets, it is essential that stress tests factor in extreme, yet plausible, scenarios for liquidity conditions in these markets, recognising that market liquidity can evaporate very quickly, particularly for complex structured financial instruments. and it is also essential to factor in increased liquidity needs linked to contingent calls, associated, for instance, with funding margin payments. capital and liquidity buffers a sizeable buffer of capital and liquidity can help a bank to withstand a shock that threatens its solvency or would otherwise leave it with insufficient liquidity to meet its obligations as they fall due. but a bank ’ s private choice as to the size of its capital or liquidity buffer may not be aligned with the socially optimal choice, as firms will not naturally take account of ( or “ internalise ” ) the implications of their distress or failure on the financial system more broadly – for example through the possibility of contagion to other firms and impairment of the financial intermediation system. that provides the justification for prudential regulation. i will not dwell here on the value and importance of capital adequacy standards in containing systemic risks – enough has been written on the basel accord and basel ii, such that this is well understood. however, consistent

sound legal basis for transactions is essential if the financial markets are to fulfil their role in effectively allocating scarce capital. financial markets operate within legal systems that not only regulate the behaviour of participants for the good of the markets as a whole, but also safeguard the property and contractual rights of those participants. prospective market participants will have greater confidence to invest or to seek finance if they feel confident, first, that the regulatory obligations and sanctions imposed upon them are predictable and, second, that the contractual rights / obligations which they acquire / undertake can be identified with certainty. furthermore, market discipline is likely to be enhanced if participants ’ legal / contractual rights and obligations are precisely defined ; the introduction of an ambiguity into the law can unsettle financial markets or exacerbate existing instabilities. legal / contractual uncertainty is therefore a potential source of systemic risk. two aspects of legal certainty are particularly crucial : contractual certainty one key element of a stable legal framework is contractual certainty. systems of contract law that show respect for formal agreements help to drive down commercial risk and therefore to promote the efficient allocation of capital. and uncertainty as to the enforceability of contracts is likely to be particularly damaging to financial markets. against this background, contracts are becoming longer and more complex as financial innovation continues apace : the documentation for a structured finance product can often run into several hundred pages, thus raising the important issue of “ documentation ” risk. legal and regulatory stability another key element is legal and regulatory stability. this is very important to the financial markets, where the ability to form complex plans with a degree of confidence as to the stability over time of external influences ( such as legal rules ) impacts directly on risk, price and, ultimately, the efficient allocation of capital. a stable planning environment is conducive to investment and, therefore, market growth. examples of harmful consequences of ambiguities in legal / regulatory frameworks include uncertainty as to the extent and scope of regulatory obligations or sanctions, and uncertainty as to how old laws will apply to dynamic and fast - changing market practices. the financial markets law committee ( fmlc ) in recognition of this, a number of countries have established groups of experts to promote greater legal certainty in financial markets. in the uk, the financial markets law committee was established in 2002. its objective was to identify issues of legal uncertainty which might give rise to material risks, and to consider how such issues might best be addressed. the committee seeks to meet this objective, first, via liaison