This financial crisis, ending a period of search for yield and increased risk-taking, has triggered various policy responses, ranging from more ad-hoc measures initially to more structured and coordinated financial sector rescue actions as the crisis evolved. Lessons drawn so far should help to devise longer-term, more encompassing and more consistent policies. Various reforms are being proposed by the financial industry as well as by official authorities and international standard-setting bodies, many of which arrive at similar conclusions regarding the causes of and remedies for the crisis. Shortcomings in risk management, including compensation schemes, governance structures, liquidity and counterparty risk, need to be addressed. Enhancing transparency by improving disclosure, valuation and ratings should help to restore market confidence. Further regulatory reforms, striking a balance between stability and growth, are needed, but should be assessed with respect to their efficiency and effectiveness. Reform areas should cover cross-border regulation for banking and finance, capital requirements, the institutional scope of regulation and financial safety nets. Financial crisis mechanisms, as well as multilateral global surveillance, should be reinforced to make the financial system more resilient, sound and efficient.

Over the past few months the world has been witnessing financial market turmoil of global dimensions (Figure 1). What had become known as the ‘subprime crisis’ and by mid-2007 had already caused bank failures, a temporary freeze on money markets and sharp drops in equity markets worldwide, has spread to a wider range of asset classes and institutions, and forced governments and central banks to step in with drastic measures. Banks’ shares have drastically lost market value. Over the past few years, low interest rates, search for yield, financial innovation and new mortgage products, combined with often imprudent (and at times fraudulent) policies pursued by mortgage lenders, built up problems of a crisis to come. Lenders’ originate-to-distribute business model, the securitization of risky mortgage loans, and the use of financial derivatives and financing vehicles to off-load these risks from balance sheets of regulated institutions helped to transfer and spread the risk in an increasingly leveraged global financial system and was bound to act as a powerful amplifier of the crisis. By several measures, global liquidity has been ample over the past few years, and has driven up various asset prices. Favorable supply conditions kept CPI inflation low and little regard to asset price inflation, in particular with respect to house prices, rendered monetary policy very accommodating. This supported a long period of historically low yield spreads, and the underpricing of risk led to excessive leverage even by otherwise more conservative financial actors. These developments were supported by incentive systems at the company level based on up-front payouts for short-run performance.