We identify current challenges for creating stable, yet efficient financial systems using lessons from recent and past crises. Reforms need to start from three tenets: adopting a system-wide perspective explicitly aimed at addressing market failures; understanding and incorporating into regulations agents’ incentives so as to align them better with societies’ goals; and acknowledging that risks of crises will always remain, in part due to (unknown) unknowns – be they tipping points, fault lines, or spillovers. Corresponding to these three tenets, specific areas for further reforms are identified. Policymakers need to resist, however, fine-tuning regulations: a “do not harm” approach is often preferable. And as risks will remain, crisis management needs to be made an integral part of system design, not relegated to improvisation after the fact.

This paper identifies some of the current key reform challenges for creating stable, yet efficient financial systems. It does so in light of lessons from the recent and past financial crises and using insights from analytical and empirical studies. The general objective of possible reforms is clear: to reduce the chance and costs of future systemic financial crises in the most efficient manner, that is, at the lowest costs to economic growth and welfare more generally. The most important conceptual and practical challenge identified in the paper is that policymakers (and market participants) need to think more about the system as a whole when engaging in their risk monitoring efforts and financial system reforms. Although some policymakers have adopted this mindset, many are still questioning its usefulness. However, the crisis has made clear that, in spite of what appeared to be individually sound and well-supervised financial institutions, well-functioning financial markets, well-diversified risks, and robust institutional infrastructures, systemic risks emerged, yet went undetected or were not addressed for some time and then created great havoc.