What concerns us most is the potential impact on financial stability. Empirical investigations recently conducted by the ECB suggest that the extensive use of fair value accounting could significantly increase the volatility of banks’ balance sheets. Valuation effects might also reduce the ability of financial institutions to react to adverse shocks, thus enhancing pro-cyclicality. These concerns are severe and great caution is warranted in the reform of accounting standards. More accurate and timely market information is also useful from a supervisory perspective. Supervisors are indeed relying increasingly on markets as a disciplining tool for financial institutions thus complementing their own activities. The future role of financial markets in the supervisory toolbox is likely to increase, despite possible periods of heightened volatility in financial markets. In particular, the reform of the capital framework for banks (Basel II) will introduce market discipline as an independent pillar of the framework. C.2  Responses to financial innovation  The process of financial innovation I referred to earlier poses at least two key challenges for policymakers. First, the supervisory framework needs to be constantly updated. Second, the legislative process needs to react in an effective and timely manner to the challenges created by market developments. 4  BIS Review 53/2003  As regards banks, the first Basel Capital Accord agreed in late 1988 has served its purpose well in terms of raising the capital levels of banks and making them safer. However, financial innovation, in particular the securitisation of banks’ assets, has left Basel I outdated and easily circumvented.

While we see significant adverse impacts of global integration, Asian economic integration, in fact, has a crucial role in helping a number of our regional economies withstand this enormous external destabilizing shock. Hence, our essential tasks are about determining an appropriate pace of further integration and making us increasingly resilient in response to the fast changing environment. To elaborate the above points, allow me to briefly talk about the developments of Asian economic integration with the world and within the region. On the trade side, there are two important on-going forces. First, international trade with the economies outside the region has risen significantly especially due to the emergence of China and India in the world trade arena, as well as policies to lower trade barriers and establish trade agreements. Second, within East Asia, intra-regional trade has grown rapidly and surpassed trade with the outsiders since 2004. The driver is vertical integration of the production networks of multinational corporations across regional economies. On the financial side, since the Asian financial crisis, East Asian economies have taken various efforts to deregulate and deepen the financial markets and liberalize their capital account. We have witnessed significantly rising financial linkages within East Asia. We have also seen rising FDI activities both within the regional economies and with other regions. Increasing regional FDI is largely a result of the aforementioned regional production networks. Portfolio investment has also increased significantly prior to the period of the subprime problem due to increasing demand of international investors for emerging market assets.