It wasn't for lack of warning. For years, experts in finance and economics have said the global financial system faced potentially catastrophic threats. Alexandre Lamfalussy, for instance, cautioned against the use of derivatives that enhance instability and increase systemic risks against the backdrop of global markets. In a 2003 interview with the BBC, Warren Buffet called synthetic products "financial weapons of mass destruction". Others disparaged the rise of "casino-style trading".

The predictions have now been borne out. As the current crisis unfolds, it has become clear that we are confronted with an event of long-lasting impact. Due to the intertwined nature of the world marketplace, meanwhile, the effects are not confined to any one country or hemisphere. Directly or indirectly, they affect us all.

Southeast European economies, like many other emerging and transitional economies, are insulated in part by the very lack of development in their financial markets. Ironically enough, their less sophisticated markets gave them less exposure to the subprime debacle which has engulfed the more advanced ones. Nevertheless, these economies too cannot escape the effects of a worldwide economic slowdown, the rise in the cost of credit and a lowered appetite for risk-taking.

The global dimension of the financial crisis is perhaps its signature quality. In the past, such crises tended to be more localised and were dealt with more easily. The difference this time has been in the rapid spread of intense financial innovation -- specifically, the modes of origination and distribution that have been pioneered by leading banks. These allowed risk to be disseminated on a large scale at the expense of transparency.

As a consequence, the emergence of the shadow banking system, largely unregulated and lacking appropriate supervision brought about more opacity in financial markets and accentuated systemic risks. Trust in the "self-healing" power of markets has not yielded the results some expected.

Securitisation of mortgages has spread the financial risks around the economy in such a way that banks' exposure to their bad loans has become, nominally, minimal. But, the repackaging of mortgages in complex collateralised debt obligations has made it difficult to identify who is holding what. Ironically, financial innovation that was designed to diminish risk at the individual or micro level has ended up in exacerbating it at the macro level, thus increasing systemic risk. Moreover, this innovation has favoured speculative trading.

Like any crisis, this one presents a set of lessons learned and a to-do list for policymakers. Two of the most important challenges ahead relate to transparency and liquidity. There will also be pressure now to impose greater accountability. As things stand now, central banks and the IMF tend to provide bailout procedures free of charge. Financial institutions might be more inclined to discipline their behaviour if they faced monetary penalties. For example, specific measures aimed at deterring speculation could be introduced.

In many ways, traditional ways of risk assessment have become obsolete. The complexity of today's financial market instruments render the models unreliable. Quantitative models employed to model investment decisions and risk assessment in financial markets have, inherently, a built-in conceptual flaw. Risk cannot be encapsulated in a few figures, so a more comprehensive description is needed. Arguably the most arduous task facing policy makers is to combat the scope for higher systemic risks when financial innovation is very intense

Regulatory practices have also been shown to be behind the times. The current system still works on the premise that banking institutions and securities markets are two different animals. But that premise is hardly feasible today. Moreover, proper attention has not yet been paid to regulating the shadow banking system. A need exists for an improved regulatory framework, one which would regulate concerned institutions as a whole.

The Basel II regulatory framework was devised to prevent crises from occurring. The current one has exposed flaws in its design, highlighting the probable need for contra-cyclical control instruments, for a mechanism linking capital requirements to the rate of change in bank lending and asset prices, and for constraints on leveraging.

Compensation packages are likely to come under new scrutiny. Managers' incentives to achieve short-term performance indicators are not always consistent with a company's longer-term expansion plans. Pressure to deliver short-term results can deliver long-term pain. Compensation schemes can be revised so that risk-taking is not rewarded at the expense of prudence.

The activity of rating agencies also stands to come under review. Conflicts of interest, blind confidence in quantitative models and insufficient attention paid to systemic risks are some of the issues here.

Increasing co-ordination among national supervision and regulatory bodies should be enhanced. But the problem cannot be fixed only at a national level; global financial markets require a global approach. Transnational co-operation is required in order to limit the potential devastating effects on the worldwide financial system and on real economies. Last but not least, the current agony points to the dangers of policy fundamentalism and the need for greater pragmatism, especially where real lives are concerned.


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