New Regulation of the Financial Industry

What makes regulators nervous with systemic risk is the likelihood that failure in one big financial institution, or a segment of the economy, may trigger failure in other banks or industrial sectors. When such failures snowball through the global financial market, there is a domino effect. In September 1998, a LTCM-type bankruptcy would have led to such an avalanche world-wide.

In an interview she gave in October 1997, Federal Reserve vice-chair Alice Rivlin pointed out that the Fed is ‘paid to worry’ (Strategy Weekly, 15 October 1997). She also implied that it was an open question, not a settled matter, as to whether the economy was on an unsustainable track. While those remarks were made with monetary policy in the background, they fit hand in glove with the way central bankers and regulators look at the management of financial risk factors. Risk factors are usually calculated using historical volatilities at a 90 per cent, 95 per cent or 99 per cent confidence level; increasingly, however, the definition and computation of risk factors is affected by extreme events which do not fit a normal distribution.