Two good slides from Axel Leijonhufvud's presentation at the 37th Economics conference organized by the Austrian National Bank:

A fallacy of composition

• "Do not put all eggs in same basket" is a good rule for a bank
• If everyone made safer by diversification, surely the economy is then safer?
• WRONG
• With (almost) everyone operating in (almost) all markets, the connectivity of the network has qualitatively changed

Herd behaviour

• Hard to opt out of process... also for those who realize risk is increasing
• Loan officer who does not lend, risk manager who does not play along, banker whose branch is not "doing enough business", hedge fund operating with less leverage than the competition... not likely to last

As you can imagine, Leijonhufvud and many other panelists mentioned the high level of leverage in the system. Though most academics know that one has to differentiate between direct leverage (loans by banks and prime brokers) and indirekt/embedded leverage (derivatives), they somehow always forget to keep in mind that the risk involved with leverage depends on the risk of the levered asset and that a stand alone leverage ratio doesn't provide any useful input. During my time as a hedge fund analyst I monitored market neutral funds who where 20 times levered but half as risky as hedge funds who where only 2 times levered but had all their money in options. I really hope regulators keep this in mind.

related items:
IFRS vs US-GAAP: European Banks Leverage Overstated, Alea