International financial stability

Until recently, low risk premia and continuing high returns were increasingly seen as permanent characteristics of the new international financial system, fuelled by unprecedented global risk diversification and supported by highly sophisticated financial instruments. This view was too optimistic, as the recent turmoil in the world's financial markets has revealed. The ninth Geneva Report on the World Economy examines the main threats to international financial stability, focusing on the implications of the major changes that have occurred in the global financial system in the past two decades. The report first examines financial stability from a macro perspective, considering macroeconomic imbalances, the decline (and recent spike) in financial market volatility and its causes, and international financial integration. It then examines stability from a micro perspective, considering the implications for stability of the growth of household risk bearing, financial sector consolidation, the emergence of new financial instruments and the growth of hedge funds. It concludes by identifying a series of policy implications regarding financial stability: * Regulators and market participants should pay particular attention to tail risk. * New regulations could require originators to retain equity pieces of their structured finance products. * Regulators need aggregate information on structured finance instrument holdings and on the concentration of risk to assist in the regulatory process. * Industry bodies should promote product standardization and accurate pricing in the structured finance market. * Credit market transactions that do not definitively transfer risk should not be treated by regulators or risk managers as if they do. * Regulators should insist that prime brokers and investors know better the positions and strategies of the hedge funds with which they transact. * Ratings firms should provide a range for the risk of each instrument rather than a point estimate or should develop a distinct rating scale for structured finance products.