Second it showed up the limitations of the models which underpin the valuation and rating of structured products and the excessive weight that had been given to them not just by the naive or unwary, but by some of the most sophisticated players in financial markets (including many of the sponsoring banks who underestimated the risks they were running in retaining super senior tranches). Third, it illuminated the adverse incentives that had been allowed to develop in the distribution chain for credit products including the strong incentives for originators to put quantity above quality, for the rating agencies to expand their scope as widely as possible, and for banks to use off-balance-sheet vehicles to finance structured credits. It may also reveal some flaws in the compensation schemes in banks. In some cases these incentives arose despite regulation, in others they were the consequence of faults in the regulatory system. Finally it showed again how measures of risk used by companies and regulators can be pro-cyclical, encouraging more risk taking at the top of the cycle and potentially exacerbating the downswing. In the last few weeks, markets have been calmer. Liquidity pressures in short-term funding markets have eased, helped in part by the co-ordinated action by central banks to address elevated funding rates over the year end (Chart 3). And, as losses have been declared it has proved possible for a number of firms such as UBS, Merrill Lynch and Citigroup to attract new capital including from Sovereign Wealth Funds.

Liquidity-constrained institutions were forced to sell assets at increasingly distressed prices, which accelerated margin calls for leveraged actors and amplified mark-to-market losses for all holders of the assets, including regulated firms. Here, too, government regulators and supervisors had insufficient data to determine the degree and location of leverage in the financial system. More generally, the crisis revealed that regulators, supervisors, and market participants could not fully measure the extent to which financial institutions and markets were linked. A critical lesson from this crisis is that supervisors and investors need to be able to more quickly evaluate the potential effects, for example, of the possible failure of a specific institution on other large firms through counterparty credit channels; financial markets; payment, clearing, and settlement arrangements; and reliance on common sources of short-term funding. A better system of data collection and aggregation would have manifold benefits, particularly if the data are shared appropriately among financial regulators and with a systemic risk council if one is created. It would enable regulators and a council to assess and compare risks across firms, markets, and products. It would improve risk management by firms themselves by requiring standardized and efficient collection of relevant financial information. It also would enhance the ability of the government to wind down systemically important firms in a prompt and orderly fashion by providing policymakers a clearer view of the potential impacts of different resolution options on the broader financial system.