Since the 1970s, economic reforms have gradually transformed financial systems all over the world and led to an enormous expansion in the role of market forces in pricing and allocating financial resources. This new financial economy has witnessed the emergence of many new financial instruments. It has also been characterized by rapid globalization and the world's capital markets are more closely integrated today than ever before. This transformation of the financial system has meant an end to the government-controlled systems that prevailed from the end of WWII until the 1970s or 1980s—and in some cases much longer. The government-controlled financial systems often appeared to be quite stable. However, this stability came at a considerable price in the form of a lack of competition, high costs of financial intermediation, and inefficient or outright wasteful allocation of scarce financial resources.

Over time, two particularly serious drawbacks became increasingly apparent: the temptation of governments to finance growing budget deficits through their privileged access to more or less captive savings; and the inability of the regulated financial systems to sanction economic policies that led to high inflation. Financial liberalization has also made it much more costly for governments to pursue unsustainable fiscal and monetary policies—which is one of the key benefits of a market-based financial system. From such an historical perspective, it is perhaps not surprising that the return to a market-based financial system, which recalls the gold standard of the XIXth Century, appears to be associated with a relatively high degree of financial volatility, which must not be allowed to degenerate into a financial crisis.

The most prominent challenges associated with the new financial economy include the following:

Destabilizing international capital flows. Many emerging countries have been benefiting considerably from substantial inflows of direct and portfolio investments. However, since 1994, massive, abrupt capital withdrawals by investors, motivated by concerns about certain imbalances, have contributed to severe financial crises in much of Latin America, large parts of South East Asia, and some transition countries.

Cross-border financial contagion. The globalization of financial markets has led many portfolio managers to invest across a large number of countries in specific sectors or according to certain credit-rating categories, thereby increasing the scope for contagion where market liquidity suddenly dries up for particular countries.

Financial sector vulnerabilities and crisis proneness. The increased opportunities for profitable investment in a market-based system tend to augment rates of return. At the same time, they expose individual investors and financial institutions to greater risks, including those associated with speculative bubbles. A market-based financial system therefore can be associated with a greater risk of systemic crises

Financial abuses. With globalized financial markets, there is a risk that it may become easier to launder illegally-acquired money and to evade taxes by investing in so-called tax shelters. There is also concern that financial regulations and oversight mechanisms in offshore financial centers are not adequate, which can threaten systemic stability.

Growing public concern about these questions and associated equity considerations have been a key factor behind the protest movement against globalization in recent years. And the protesters in turn have increased the urgency for policymakers to address the problems. Two conclusions stand out in the recent financial crises. One is that for market forces to operate effectively, market participants need to understand the risks they take on. The other is that a robust financial infrastructure is absolutely essential to reduce the likelihood that changes in market sentiment lead to self-fulfilling expectations of financial collapse and unjustified financial contagion across borders.

The international community has responded to these findings by developing and promoting the implementation of a range of international standards of good practices for economic policies and for the financial infrastructure. As countries implement these standards, the risk of disruptive shifts in market sentiment in response to surprises should diminish while their financial systems' resilience to financial crises should be enhanced. The IMF and the World Bank are particularly well placed to assist countries in the assessment and implementation of these standards.

The IMF is producing modules on data dissemination and fiscal transparency. The World Bank covers accounting and auditing, corporate governance, and insolvency and creditor rights. The IMF and the World Bank jointly undertake assessments of financial sector standards, which are aimed a assessing a country's financial sector strengths and vulnerabilities. Many other reinforcements are taking place in the IMF's crisis detection, prevention, and resolution policies. For example, to enhance our understanding of the constantly evolving international capital markets, the IMF's analytical work in this area has been concentrated in a new International Capital Markets Department, which began operations on August 1, 2001. In addition, the Fund's ongoing monitoring and analysis of developments in both member countries and the global economy is geared toward identifying vulnerabilities. This includes the development of analytic tools to provide early warning of looming crises. These indicators will be used as an internal tool by the IMF to sharpen our attention to potential crises at an early stage and will help the Fund provide appropriate advice to the relevant authorities sufficiently in advance to increase the chances that corrective measures will be taken in time.

The IMF has also streamlined its lending policies in an effort to play a more effective role in preventing and resolving crises. This includes the establishment of new facilities, including the Contingent Credit Line (CCL), which is available to member countries with a strong track record and should deter speculative attacks. This said, while much can be done to reduce the risk of financial crises, crises do occur. However, the costs of a crisis for the country concerned and for the rest of the world can be reduced considerably. Most importantly, the country must take the measures viewed as indispensable for addressing the root causes of the crisis. In support of such measures, the IMF and perhaps other official creditors provide temporary financial assistance. The country's private creditors may thereby accept to roll over existing credit lines and maturing bonds and even to provide new financing. As a result, a liquidity crisis is prevented from turning into a costly solvency crisis. Finding a constructive role for the private sector in the crisis resolution process is therefore a key priority for the IMF.