Potential for instability over-hyped, says Ferguson

The dynamic hedging of prepayment risks in mortgage-backed securities, the trend towards advanced risk modelling and the growth of the credit derivatives market “appear to demonstrate that financial engineering can...contribute to financial stability by enabling firms to disperse risk throughout the financial system,” Ferguson said.

Concerns that common approaches to risk management, such as value-at-risk modelling, may be promoting herding behaviour is unfounded, and regulators must not overestimate the role risk models play in decision making, Ferguson continued. “Risk managers get useful information from risk models. But judgment, experience, limits and procedures for exceptions also play significant roles in risk management,” Ferguson said. “As a consequence, risk models are never likely to be the dominant driver of the actions of financial firms and are therefore unlikely to generate significant herding behaviour.”

Furthermore, fears that insurance companies are unable to manage credit derivatives are also unwarranted, said Fergsuon.

Regulators should keep enough distance from the markets to give financial innovations such as credit derivatives a chance to succeed, Ferguson added. “The new market for credit derivatives has grown largely outside of traditional regulatory oversight, and...evidence to date suggests that it has made an important contribution to financial stability in the most recent credit cycle.”