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Sending the herd off the cliff edge

Author: Avinash Persaud

G7 policy makers chant three things about international Finance: more market-sensitive risk management, stronger prudential standards and improved transparency. These are likely to be a positive force in the long run when markets are better at discerning between the good and bad. But in the short run there is growing evidence that market participants Find it hard to discern between the good and the unsustainable, they often herd, and contagion from one crisis to another is common. The problem is that in a world of "herding", tighter market-sensitive risk management regulations and improved transparency can turn events from bad to worse, creating volatility, reducing diversification and triggering contagion.

How can this happen?

The growing fashion in risk management, supported by the Basel Committee, is a move away from discretionary judgements about risk and a move to more quantitative and market-sensitive approaches. This is well illustrated by how banks now tend to manage market risks by setting a DEAR limit - daily earnings at risk. DEAR answers the question: how much can I lose with, say, a 1% probability over the next day? It is calculated by taking a bank's portfolio of positions and estimating the future distribution of daily returns based on past market correlation and volatility.

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