The recent crisis has revealed how the real world deviates significantly from the assumption of perfect markets: information is asymmetrical, risk can be mispriced for sustained periods, and economic decisions are frequently guided by complex behavioural considerations rather than rational calculations. 7. Second, the cost of failure in financial systems is much higher than in other markets. The risk of destructive transmission is far greater with financial networks spanning many segments of the real economy. When companies fail, capital is reallocated to more productive uses in a process of creative destruction. In contrast, when financial institutions fail, capital is destroyed in a process that can feed on itself and lead to systemic instability. 8. Robert Shiller from Yale University, one of the few economists who predicted the crisis, argues that “we have to distance ourselves from the presumption that financial markets always work well and that price changes always reflect genuine information”. It is this misguided belief that prices always reflect fundamentals, that leads to asset bubbles. Government regulation is therefore imperative. Effective regulation and supervision of the financial sector is necessary to promote prudent behaviour and sound risk management and minimise the risk of financial shocks. 9. But we should guard against drawing the wrong lesson from the crisis: it is not about more regulation and less markets. The new financial landscape paradoxically requires both – better regulation but also better functioning markets. BIS central bankers’ speeches  1  10. Market competition remains the best way to promote innovation and create prosperity.

Regulation must not stifle markets but seek to make them work better. In the financial sector, this means a judicious mix of rules and incentives for stronger capitalisation, more effective risk management, better transparency, and sharper market discipline. This has been central to the approach taken by the Monetary Authority of Singapore – never hesitating to impose high standards of prudence and financial discipline but always careful to do so in a manner that does not undermine enterprise and innovation. 11. Financial innovation – especially in derivative products – has been blamed as a cause of the crisis. This is not quite correct. Innovation has been a feature of finance for decades. The crisis was caused fundamentally by failures in macroeconomic policies and financial supervision. Monetary policy was too easy for too long in too many countries. This led to low interest rates and lax lending standards that precipitated unsustainable housing booms, mainly in the United States but also in other countries. Financial supervision failed to detect and correct the build-up of leverage in the system, especially in the shadow banking sector. Complex financial products obscured the risks in sub-prime lending and transmitted these risks across the financial sector. As Edwin Truman from the Petersen Institute puts it, “Financial engineering contributed to the market dynamics once the crisis got underway, but it was not ‘the cause’ of the crisis.” 12. Regulation should therefore not restrict financial innovation but seek to create conditions in the market that promote effective risk management.