Thoughts on financial derivatives, systematic risk, and central banking: a review of some recent developments

This paper critically reviews the literature examining the role of central banks in addressing systemic risk. We focus on how the growth in derivatives markets might affect that role. Analysis of systemic risk policy is hampered by the lack of a consensus theory of systemic risk. We propose a set of criteria that theories of systemic risk should satisfy, and we critically discuss a number of theories proposed in the literature. We argue that concerns about systemic effects of derivatives appear somewhat overstated. In particular, derivative markets do not appear unduly prone to systemic disturbances. Furthermore, derivative trading may increase informational efficiency of financial markets and provide instruments for more effective risk management. Both of these effects tend to reduce the danger of systemic crises. However, the complexity of derivative contracts (in particular, their high implicit leverage and nonlinear payoffs) do complicate the process of regulatory oversight. In addition, derivatives may make the conduct of monetary policy more difficult. Most theories of systemic risk imply a critical role for central banks as the ultimate provider of liquidity. However, the countervailing danger of moral hazard must be recognized and addressed through vigilant supervision.