Has Financial Risk Really Worsened?

Summary

Each generation believes that it faces greater difficulties, greater volatility in financial markets, than ever before. This is currently blamed on globalisation, derivatives and deregulation. But the evidence shows that, apart from Japan, volatility is not now (in 1995) historically high. Globalisation is no more advanced than it was before 1914, and should, anyhow, allow diversification and thereby reduce risk.

Similarly, there is no strong evidence that derivatives have destabilised spot markets, though OTC derivatives may have reduced transparency; and they have certainly further complicated financial regulation. Some even worry whether these structural processes might have weakened the authorities’ grip on domestic monetary policy, a concern which is shown to be largely groundless. The additional leverage provided by derivatives, and certain aspects of dynamic hedging, may, however, have further complicated the authorities’ ability to maintain a pegged exchange rate, but the basic difficulty of that exercise was known to be present beforehand.

In contrast, in the field of financial regulation, the speed, leverage, and complexity of international position-taking makes the possibility of regulation via externally imposed ratios, monitored via occasional balance sheet snapshots, of dubious viability. It will be necessary to rely more on internal managements’ risk controls.