The root cause of the crisis was a widespread undervaluation of risk. This included an underpricing of the unit of risk and an underassessment of the quantity of risk that financial operators took upon themselves. Several policymakers had indicated during 2006 and early 2007 that market participants needed to prepare for a significant correction. As chairman of the global economy meetings of central bank governors, I myself reported my colleagues' sentiments on this matter. At the same time, several financial stability reports, including from the European Central Bank, the Bank for International Settlements, the Financial Stability Forum and other organisations, had analysed vulnerabilities and warned of the emerging weaknesses.
A number of factors had contributed to the financial environment that prevailed until mid-2007. The spreading of the “originate and distribute” banking model led to a separation of those holding credit risks from those monitoring and managing them. Investors assumed that originators would perform proper risk management, but had no guarantee that this would be the case. They put full faith in the ability of rating agencies to draw up risk assessments for instruments that were new. Moreover, some large financial institutions showed a massive concentration of risk, considering the overall size of their balance sheets and capital. While the extensive spreading of risk is generally a stabilising factor at the system level, in extreme circumstances, such as a global loss of confidence, the impact is by definition systemic. A loss of confidence on precisely that scale occurred in mid-September this year.
While we are managing the current situation, we also have to start designing ways to strengthen the global financial system in a sustainable way. The FSF has been drawing lessons from the crisis and its work has been built upon by the international community. In this context, three factors in particular have to be addressed in order to correct the widespread and massive undervaluation of risks: short-termism, lack of transparency and excessive pro-cyclicality.