can protect that economy when one of those financial sectors undergoes a shock. australia serves as an interesting test case in the most recent asian financial turmoil. despite its close trade and financial ties to asia, the australian economy exhibited few signs of contagion from contiguous economies, arguably because australia already had well - developed capital markets as well as a sturdy banking system. but going further, it is plausible that the dividends of financial diversity extend to more normal times as well. the existence of alternatives may well insulate all aspects of a financial system from breakdown. diverse capital markets, aside from acting as backup to the credit process in times of stress, compete with a banking system to lower financing costs for all borrowers in more normal circumstances. over the decades, capital markets and banking systems have interacted to create, develop and promote new instruments that improved the efficiency of capital creation and risk bearing in our economies. products for the most part have arisen within the banking system, where they evolved from being specialized instruments for one borrower to having more standardized characteristics. at the point that standardization became sufficient, the product migrated to open capital markets, where trading expanded to a wider class of borrowers, tapping the savings of larger groups. money market mutual funds, futures contracts, junk bonds, and asset - backed securities are all examples of this process at work. once capital markets and traded instruments came into existence, they offered banks new options for hedging their idiosyncratic risks and shifted their business from holding to originating loans. bank trading, in turn, helped these markets to grow. the technology - driven innovations of recent years have facilitated the expansion of this process to a global scale. positions taken by international investors within one country are now being hedged in the capital markets of another : so - called proxy hedging. building financial infrastructure but developments of the past two years have provided abundant evidence that where a domestic financial system is not sufficiently robust, the consequences for a real economy of participating in this new, complex global system can be most unwelcome. it is not surprising that banking systems emerge as the first financial intermediary in market economies as economic integration intensifies. banks can marshal scarce information about the creditworthiness of borrowers to guide decisions about the allocation of capital. the addition of capital market alternatives is possible only if scarce real resources are devoted to building a financial infrastructure – a laborious process whose payoff is often experienced only decades later. the process is difficult to initiate

helped engender a downsizing of public ownership of commercial banks in europe, coupled with rapid development of heretofore modest capital markets, changes which appear to be moving continental europe ’ s financial system closer to the structure evident in britain and the united states. continental european countries may gain an additional benefit from the increased development of their capital markets. with increased concentration of national banking systems, which will likely be followed by increased concentration of europe - wide banking, comes the risk of an unusually large impact should the health of a megabank become impaired, causing the bank to curtail its lending. having well - developed capital markets would likely help to mitigate these effects, as more firms would have alternative sources of funds. conclusion improving domestic banking systems in emerging markets will help to limit the toll of the next financial disturbance. but if, as i presume, diversity within the financial sector provides insurance against a financial problem turning into economy - wide distress, then steps to foster the development of capital markets in those economies should also have an especial urgency. moreover, the difficult groundwork for building the necessary financial infrastructure - improved accounting standards, bankruptcy procedures, legal frameworks, and disclosure - will pay dividends of their own. the rapidly developing international financial system has clearly intensified competitive forces that have enhanced standards of living throughout most of the world. it is important that we develop domestic financial structures that facilitate and protect our international financial and trading systems, a process that will require much energy and commitment in the years ahead.