##s economic efficiency. financial competition is threefold : ( i ) within the intermediary - based system ( banks, mutual funds, insurance companies … ), ( ii ) between intermediaries and markets in a given country and ( iii ) between national financial systems. • financial intermediaries are also key market participants. they contribute to the effective functioning of markets. banks, in particular, are the ultimate providers of liquidity ; a function which is essential in ordinary times and can become critical in periods of stress. • this is why a diversified financial system can help and absorb shocks and, in most extreme circumstances, mitigate the consequences of financial crisis. financial crises have occurred in countries with differing financial structures, suggesting that the specific organisation of the financial system does not matter. yet, i will quote alan greenspan 5 who argues that “ multiple alternatives to transform an economy ’ s savings into capital investment act as backup facilities should the primary form of intermediation fail. in 1998 in the united states, banking replaced the capital markets. far more often, it has been the other way around [ … ]. ” ii financial systems, risk allocation and economic growth one major function of a financial system is to reallocate risk between different economic agents. through such reallocation, borrowers can tailor their risk profiles and therefore, are provided with greater access to capital. savers become better able to diversify and to manage their portfolios. gains are unquestionably generated from the efficient capital allocation resulting from improved risk sharing. for instance, high - return ( and innovative ) projects, which tend to be riskier, will be better financed. for investors, efficient risk management may increase their ability to hold portfolio of high - risk projects while, at the same time, reducing their overall exposure through diversification. r. levine ( 2002 ) : “ bank - based or market - based financial systems : which is better? ” william davidson working paper n°442. v. dolar and c. meh ( 2002 ) : “ financial structure and economic growth : a non - technical survey ”, working paper 2002 - 24, bank of canada. a. greenspan ( 1999 ) : “ do efficient financial markets mitigate financial crises? ”, remarks before the 1999 financial market conference of the federal reserve bank of atlanta. a risk sharing and financial innovation in the past thirty years, financial systems have undergone sweeping changes. financial innovations, such as the development of the derivatives markets and

“ pay - as - you - go ” systems do not share risks between generations. in fact, they transfer the income risks of retired people to working people and their dependents who thereby bear the risks of both generations. intergenerational social security ’ s defining characteristic would be a plan to pool the risks that different generations hold, including macro economic risks. c innovation and risk should we be somehow concerned by the speed of this innovation process or, as r. rajan has put it, " has financial development made the world riskier "? according to a “ benign ” view, financial innovation has improved the efficiency and increased the resilience of the financial system. risks are spread among more agents, willing and able to have them. financial intermediaries are provided with sufficient incentives to improve their risk - management techniques. therefore, the financial system is better able to absorb shocks without increasing the effects of such shocks on the economy. broadly speaking, this seems correct to me. the financial system has coped with remarkable success and with few signs of instability with the various episodes of financial turmoil and shocks in recent years. market - functioning difficulties were short - lived. the impact of these episodes on the real economies of industrialised countries was generally limited. however, we want to make sure that financial institutions and markets help to absorb and redistribute the shocks occurring in the real economy. we don't want them, in general, to be an additional source of shocks. in this regard, two specific questions come to the mind of policy makers. the first relates very simply to our ability to understand what is going on in the financial system when innovations permanently introduce additional layers of sophistication and complexity. as is often the case with financial innovations, evaluating the risk they entail requires the use of complex techniques that are not always sufficiently tried and tested 6. the second issue, singled out by rajan himself, is about incentives, an issue made especially important by the shift from depository intermediation to professional asset management. the system of incentives under which managers operate should be closely and permanently aligned with the interests of investors. this is, in my view, a very productive area for future research for academics and regulators alike. let me conclude by two points about central banks. first, they have a natural interest in the efficiency and stability of the financial system. asset prices are a key channel through which monetary policy is transmitted to the real economy. the ability of the financial system