Increasing innovation in financial markets together with rapidly growing cross-border transactions aided by favourable low-interest rate conditions in developed markets, against the background of precarious regulatory frameworks, have created the premises for a potentially devastating financial crisis.

Financial innovation brings about benefits when it fosters dynamism and economic growth. But it also entails significant risks; the more complex financial innovations are and the more broadly based their use is, the more ensuing, systemic risks can be. In other words, the fragility of financial systems can increase substantially. Recent events in international financial markets show it amply. As a matter of fact, complexity has become a key issue to deal with in both internal risk management (by banks) and in the overall functioning of financial markets.

Addressing the challenges posed by risky financial innovations and misconduct by market participants is not an easy task. When handled in an inappropriate way positive innovation stifled. On the other hand, not taking appropriate measures would be quite damaging under the current circumstances and might lead to massive erosion of confidence in the financial sector.

At the time of writing, a combination of cyclical and structural factors has lead to a situation which could threaten financial stability worldwide. As the current financial turmoil has been unfolding it becomes clearer that the effects of the initial sub-prime crisis are spreading across other asset markets, increasing the likelihood of a global credit crunch and an economic downturn. The breadth of the ongoing crisis has brought into attention, once again, issues related to the transparency and liquidity of financial systems.

Excessive risk taken by lenders, at the expense of necessary prudence, together with a high degree of financial engineering have allowed complex investment products to be sold to a wide range of investors. The emergence of the so called ‘shadow banking system’ - which is exempt, to a large extent, from regulation and supervision (as it is experienced by the banking system) - has facilitated theproliferation of highly leveraged investment vehicles and has accentuated systemic risks. With the implicit lengthening of the intermediation chain, it becomes increasingly difficult to assess the nature and magnitude of the risk involved or to locate those who bear the risk; markets have become opaque. These effects have beencompounded by the lack of adequate due diligence by banks and investors.

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. Two of the most important policy challenges ahead are those related to transparency and liquidity. But, arguably, the most arduous task is to combat the scope for higher systemic risks when financial innovation is very intense.

In hindsight, recent crises, such as the LTCM or Enron, can be seen as stress tests for the financial system. Although these crises were quite severe, their global effects were contained in the end because, at those periods of time, the financial markets’ degree of sophistication did not, arguably, reach the level and depth as witnessed nowadays.Delays in the effective implementation of changes in regulatory systems are partially, at the root cause for the turmoil we are witnessing nowadays.

One feature of the current crisis is the high degree of uncertainty regarding the distribution and extent of incurred losses. This uncertainty, lack of trust, have made investors to take a flight for quality, which, in turn, has led to an increased liquidity demand. Central banks have responded to that by injecting large amounts of liquidity in the money market. However, the pursuance of such a policy is unlikely to bring an end to the current crisis for two reasons. First, this measure does not address the root of the problem, namely that of the underlying fear that banks’ balance sheets are in a precarious position. At the moment, the existence of counterparty risk is prevailing in the money markets. And second, the liquidity does not reach the market participants which mostly need it – i.e. the ‘shadow banking system’.

In the light of the developments mentioned above there is a need for the implementation of appropriate strategies for action. This paper brings together points of view expressed by academics, market participants or analysts. These views focus on a few directions centered on issues such as enhancing transparency, resolving conflicts of interest, incentive schemes that encourage excessive risk-taking at the expense of prudence, and, not least, improving the existing regulatory and supervisory frameworks. This crisis is an additional strong proof that free markets are not tantamount to completely deregulated markets. This paper also reflects our own thinking on how to respond to the current crisis.

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