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 However, financial innovation, in particular the securitisation of banks’ assets, has left Basel I outdated and easily circumvented.

The structure of this policy discussion will be based around three themes: the importance of  BIS Review 53/2003  3  transparency in order to overcome information-related problems, reactions to financial innovation and, lastly, increasing integration and potential international spillovers of crises. C.1  Responses to the lack of information  The information imperfections illustrated by recent episodes of market turmoil notably include incomplete and disparate published information by firms traded on the markets. I see key challenges in harmonising and improving the availability of information. The ultimate objective is to allow for rational investment decisions and a correct pricing of risk. Much has been done at global level and by the EU Financial Services Action Plan to increase the degree of transparency supporting the working of financial markets. This action has intensified since the high-level corporate failures in the United States, which demonstrated that there is ample scope for misleading investors through the manipulation of accounts and the information disclosed. Maybe the most eye-catching reform - and a key challenge for companies and banks in particular - is the introduction of new accounting standards. The International Accounting Standard Board and the Federal Accounting Standard Board are both constantly trying to improve and harmonise these frameworks on both sides of the Atlantic. Indeed, harmonised and high quality accounting standards could make a significant contribution to the integration and efficiency of financial markets, and these could also help in Europe where the differences in accounting rules could affect the cross-country comparability of firms’ accounting information.