In recent years there have been fundamental changes in global financial markets. Non-bank financial institutions have grown enormously, largely at the expense of banks. Institutional investors are playing an increasingly important role in capital markets. Financial market innovation and integration are proceeding rapidly. And huge transfers of risk are taking place, not only between countries but also from financial institutions to other sectors.

The globalization of financial markets has great potential benefits for economies, but also poses considerable challenges. There are implications for the private sector, for governments and for international financial institutions, all of which have responsibilities in promoting and protecting global financial stability. Financial instability can have significant and adverse effects on the real economy. This is one reason why the IMF, in particular, is striving to deepen its knowledge of the financial sector and tie its work in this area to its efforts in other areas, thus enabling it to give its members good advice on how to maximize benefits and minimize risks.

As a whole, the public sector—which includes governments, central banks, financial sector supervisors and international financial institutions—has responsibilities in at least three key areas. First, it must promote macroeconomic stability at both the national and the global levels. Second, the public sector must provide a supervisory and regulatory framework that is conducive to well-functioning and stable financial markets. And third, the public sector must understand the constantly changing world of international capital flows, be alert to possible sources of instability, and act appropriately to confront them.

At the national level, the responsibilities of governments and central banks for macroeconomic stability are clear. Governments must set responsible fiscal policy. Central banks should keep inflation down and should be predictable and consistent in their monetary management. Recently, central banks worldwide have been doing a good job at this, demonstrating growing independence and greater skill in combating inflation. But as monetary authorities focus on holding down inflationary expectations, it is particularly important that they give clear signals of their intentions to avoid unnecessary volatility in financial markets.

At the global level, monetary policy responsibilities are less clear, and too often governments point fingers at other countries to justify their own inaction. As a result, while some tentative steps have been taken, much more needs to be done. This is important because global imbalances have grown larger, and there is a real risk of a disorderly adjustment. It is in everyone's interest to take action. Fiscal adjustment in the United States would make an important contribution to reducing global imbalances, and would leave the U.S. better placed to cope with the pressures of an aging population. European governments can promote better growth performance in their own economies (and sustainable global growth) by reducing the rigidities prevailing in their labor, product and service markets. This would also improve the ability of their economies to withstand shocks. In emerging Asia, there is scope for greater exchange rate flexibility and increased domestic demand. China and Malaysia have both taken steps toward greater exchange rate flexibility, and other countries in Asia have increasingly been moving in this direction. More needs to be done in this area. Greater exchange rate flexibility is very much in China's interests because it would encourage monetary independence and strengthen the economy against external shocks. At the same time, it could spur domestic consumption by raising real household incomes.

As governments and central banks continue to create the right supervisory and regulatory framework for financial markets to thrive, it is important that they adapt to the evolution of financial markets. For example, as the role of asset management companies, including hedge funds, grows in importance, government regulation will need to go beyond the traditional focus on banking and insurance, and address new issues of transparency and disclosure, as well as problems of conflict of interest. Regulators and supervisors also have to remain alert to contagion effects—the spreading of crises across borders and markets.

The IMF plays an important role in advising on supervisory and regulatory frameworks, especially through its Financial Sector Assessment Program. This program has now become an established and valued feature of the work of the IMF and World Bank, and many countries—especially in Europe—have now undertaken the program.

Monitoring the global financial system is perhaps the most difficult task for governments and for the IMF. It is essential to understand how global assets are allocated, and how to detect potential problems that could lead to financial crises. Policy makers need to be able to assess the likelihood of abrupt changes in capital flows that might undermine the financing of payments imbalances or the stability of emerging market economies. And international organizations should try to develop early warning systems that can alert policy makers to problems before they are imminent. The Fund is stepping up its work in this area, and is integrating its work on financial markets more closely with the economic advice it gives to individual countries.

The private sector also has a pivotal role to play. Like the public sector, it also has important responsibilities in ensuring the stability of financial markets. These include sound risk management practices, due diligence, and professional credit and risk analysis. Further, the private sector plays a key role in corporate governance—including checks and balances within institutions—not only in the banking sector, but also in the asset management sector.

But there is also an area where governments and the private sector have a shared responsibility. As pay-as-you-go pension systems diminish in importance and defined benefit pension plans become rarer, individuals are becoming responsible for their own financial futures in a new way. Therefore it has become essential for individual savers to diversify their asset holdings just as it always has for corporations. An education on financial markets, therefore, especially on the trade-off between risk and return, becomes even more important. But providing this education is not only the responsibility of governments. If they are wise, private companies will recognize that they also have a responsibility to educate their clients. If they do not, then losses are likely to be met not just with disappointment but with anger, and such anger will inevitably translate into pressure for public intervention. Transparency, consumer education, and sound corporate governance all serve the interests of financial sector businesses as well as their consumers.

In sum, there have been very positive developments in financial markets. There are ongoing strong efforts to improve risk management. There are increased efforts to transfer knowledge and strengthen corporate governance in the financial sector. And joint efforts by the public and private sectors have made it possible to head off crises. All of this gives cause for optimism for the future stability of financial markets.