Derivatives both a help and a danger, says BoE deputy governor

Derivatives are both a help and a danger to global financial stability, according to the deputy governor of the Bank of England, Andrew Large.

While derivatives can help banks to weather financial crises by transferring away risks, they can also lead to unpredictable and dangerous concentrations of risk elsewhere, Large said in a speech at the London School of Economics yesterday.

He said the world was sometimes portrayed as being split into two camps. “The bullish view is led by governor [Alan] Greenspan [of the US Federal Reserve]," said Large, and the bearish camp is led by Warren Buffet - the billionaire investor who has branded derivatives a “time bomb”.

“My view would be that both schools of thought are right,” said Large.

He was speaking on the challenges involved in financial stability oversight, his special area of responsibility at the Bank of England. One of the biggest changes in this field, he said, is that “the degree of complexity and interconnectedness has increased dramatically in recent years". He said these were due to market liberalisation, technological advance and the development of new instruments for transferring risk, all of which brought new benefits and threats.

“The complex and diverse operations of hedge funds can help to arbitrage away pricing mistakes, and to integrate financial markets,” he said. “But they also raise new questions for financial stability oversight."

He also warned of the potential “hazards” of banks' reliance on computer modelling for their risk management. He said these models are only as good as the assumptions on which they are based, and can give “false reassurance” that there will enough liquidity in times of crisis.

Large said the role of central banks and regulators was to “think about what could go wrong and to be ready accordingly".”

“We cannot and should not aspire to a zero-risk solution, but we do need to be prepared to take measures to restore confidence if things go wrong,” he said. He added that the Bank of England would always consider bailing out institutions that get in trouble - as a last resort - because confidence in the system was in the interest of society as a whole.

Large joined the Bank of England in September 2002 from Barclays, where he was chairman of the board risk committee. Before that he had been chairman of the Securities and Investments Board, the predecessor of the Financial Services Authority.