Do Market Risk Management Techniques Amplify Systemic Risks

From 2002 to early 2007, the decline in volatility in the global economy and fi nancial markets was refl ected in lower measures of market risk, which encouraged fi rms to increase their risk-taking, thereby enhancing market liquidity and resulting in even lower levels of volatility (Figure 2.1). Conversely, shocks in an environment of heightened risk-taking could result in a rapid deterioration of such a benign environment, as reductions in risky positions lead to rising volatility and asset correlations, a reduction in market liquidity, and a further retrenchment in risk-taking.1 As similar market risk measurement techniques spread across more institutions, the question arises as to whether the potential for reinforcing behavior has increased, given that past and current episodes of stress indicate that many fi nancial institutions react by following the basic tenets of their risk management systems by selling risky assets, calling in higher-quality collateral, and increasing margin requirements.2