, in : econometrica, vol. 71, no. 1, pp. 173 - 204. brunnermeier, m. and l. h. pedersen ( 2009 ), “ market liquidity and funding liquidity ”, in : review of financial studies, vol. 22, no. 6, pp. 2201 - 2238. regulation ”. 4 the policy conclusions include both crisis prevention – with recommendations like the introduction of macro - prudential regulation or liquidity regulation – as well as crisis management with analyses of toxic asset purchases, asset guarantees or mortgage subsidies, for example. notwithstanding the important theoretical advances to which markus brunnermeier contributed substantially, there is still much to be learnt about the root causes, the triggers and the propagation mechanisms of the financial turmoil, and how precisely it spread to the real sector, causing a deep financial and economic crisis arising from negative feedback loops between the two sectors. the severe challenges for policymakers posed by the existing knowledge gaps are reflected in the very controversial debates about the optimal responses to mitigate and resolve the current crisis and to prevent future crises from occurring. quick progress on these and related research topics is essential for the ecb both from a monetary policy and a financial stability perspective. while at present the ecb already performs certain tasks which shall contribute to safeguarding the stability of the financial system, it is foreseen that the range of tasks and responsibilities of the ecb related to financial stability matters becomes substantially enlarged. according to the recent proposal by the european commission on the reform of financial supervision in the european union, drawing on the recommendations of the de laroisiere high - level group, the ecb would play an important role in a new european systemic risk council to be in charge of macroprudential financial supervision in the european union. for the ecb to effectively perform such tasks requires, among other, major investments into a supporting macro - prudential analytical infrastructure, for example the development and implementation of a suite of early warning signal models and the significant extension of existing macro stress testing models. but we also need innovative approaches on optimal policy responses once macro - prudential risks have been identified, since the european systemic risk council will also have to issue policy recommendations. in contrast to the assessment of systemic risks where we have a basis to build on and where our staff has also made research contributions to the literature, macro - prudential regulation or policy is a relatively new concept for which a

of the underlying causes. markus brunnermeier ’ s research has played a prominent role here. for instance, his research on bubbles sheds light on how institutional frictions and strategic considerations can lead to significant mispricings of assets. 2 while market participants may be aware of the flawed asset valuation, the lack of common knowledge can lead to a build up of the bubble and hinder its bursting. this approach departs from the conventional market efficiency view that rational traders will immediately stabilise prices by shortening overvalued assets and, by contrast, integrates important aspects of trading behaviour into the mainstream of economics and finance. when a bubble bursts and risk is re - assessed, financial institutions suffer losses. in the current crisis, uncertainty over the size and location of exposures of banks or banksponsored conduits to “ toxic ” assets translated into funding liquidity problems. a paper by brunnermeier and pedersen, “ market liquidity and funding liquidity ” explains how such funding problems can affect market liquidity and lead to mutually reinforcing liquidity spirals. 3 balance sheet constraints of financial intermediaries can naturally lead to market illiquidity and the expectations of future liquidity risk can lead to panic and more asset price declines. indeed, liquidity shortage was one of the key propagation mechanisms of the current crisis which illustrates a negative externality that fire - sales by individual institutions can impose on the financial system as a whole. it is also one of the factors that contributed to prolonged tensions in the interbank market as banks were reluctant to lend to each other to minimise counterparty exposures. these markets are crucial for banks ’ liquidity managements and also for the transmission of monetary policy. the work on funding and market liquidity also offers possible mechanisms for the resolution of liquidity spirals. the key policy prescription is to improve the funding liquidity of financial institutions in order to prevent solvent institutions from being driven out of business by protracted illiquidity. this policy has been followed extensively by the eurosystem over the recent past. liquidity spirals also create an important pro - cyclical mechanism in the financial system. this issue is discussed in the draft notes on the next geneva report on the world economy written by professor brunnermeier and co - authors on “ the fundamental principles of financial abreu, d. and m. brunnermeier ( 2003 ), “ bubbles and crashes ”