The right incentive structure has to be in place as well. Private capital markets are the fundamental building block of the capitalist system of resource allocation across activities and over time. Such markets can function properly only if investors bear the costs of their bad decisions and bad luck and reap the benefits of their good decisions and good luck. This is as it should be, since investors earn premiums to compensate for the risks of such investments. Despite the increased sophistication and complexity of financial instruments, it is not possible to take account in today's market transactions of all possible future outcomes.
Markets operate under uncertainty.
It is therefore crucial to market performance that participants manage their risks properly, and this is true at the national and official levels of both industrial and developing countries as well as at the level of individual private-sector firms. The type of investment instruments issued also can help contain financial stresses. It is no doubt more effective to have mechanisms that allow losses to show through regularly and predictably than to have them allocated by some official entity in the wake of default. In the former case, the private sector will be better able to price risk, making the judgment about new credit decisions more informed. This is particularly so in the international arena, where national sovereignty severely limits the reach of national bankruptcy laws as well as the scope for any realistic hopes for international bankruptcy procedures.