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Diversity and Fragility in the Global Financial System

Why Basel III could make the system more fragile

The diversity of buyers and sellers and of long- and short-term investors is a necessary condition for a successful market economy. Some aspects of Basel III may threaten it, which will affect all market participants, both regulated and unregulated.

One reason why the 2008 meltdown wasn’t worse than it was is because not everybody was selling at the same time. Long-term investors, such as pension funds, stepped in to buy cheap assets, critically breaking the fall in asset prices as banks, investment banks and hedge funds scrambled to raise cash.

The argument for maintaining the balance of buyers and sellers has never been stronger, yet two provisions of the Basel III Fundamental Review of the Trading Book (FRTB) may upset it.

Drawing on the insights of global risk professionals interviewed by Frances Cowell and Matthew Levins for Crisis Wasted? Leading Risk Managers on Risk Culture, published by Wiley, this article explains why diversity in the financial system is key to ongoing stability and how two seemingly benign measures aimed at correcting some shortcomings in Basel II and further strengthening the systemwide capital base can aggravate the problem of crowded trades, pro-cyclicality and instability. It concludes by describing an alternative approach.

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About The Hedge Fund Journal

INFORMING THE HEDGE FUND COMMUNITY With access to some of the industry’s biggest names and an astute and talented group of writers and contributors, The Hedge Fund Journal has established itself as a trusted source of information on the hedge fund industry.