An interim report from the Financial Stability Forum finds that the market should correct many of the problems revealed by the credit crunch, but there are challenges for regulators, too.

The FSF’s Working Group on Market and Institutional Resilience has sent an interim report to G7 finance ministers and central bank governors. It discusses the working group’s views on adjustments and near-term challenges in the financial system; the causes of and weaknesses revealed by market turbulence; and broad policy directions for strengthening the resilience of key elements of the financial system.

The proposed policy directions are in six areas: supervisory framework and oversight; underpinnings of the originate-to-distribute model; the uses and role of credit ratings; market transparency; supervisory and regulatory responsiveness to risks; and, the authorities’ ability to respond to crises. The group will develop specific recommendations for its report in April.

The report notes that, “The wider ramifications for credit markets and financial counterparties of the difficulties facing the monoline insurance sector are illustrative of the complex network of interdependencies in the financial system and of the need for co-operation amongst authorities and market participants to respond to current challenges.”

The FSF says that the most immediate task for market participants is to rebuild confidence in the creditworthiness and robustness of financial institutions. “This is a necessary condition for the re-establishment of adequate market liquidity and credit intermediation,” it says. “Such a confidence-building process is underway but can only be solidly achieved through appropriate valuation of assets and risk exposures and adequate capital and liquidity buffers.”

“While authorities should avoid hasty prescriptive measures, official policy responses can buttress these market efforts,” it adds. “Authorities need to ensure that an appropriate incentive structure is in place and that tail risks are adequately controlled. And they must decide where a greater element of prescription about transparency will be necessary, given potential collective action problems and other market failures. Authorities should not preempt or hinder market-driven adjustments, but monitor them and add discipline where needed.”

The FSF points out that it is difficult to foresee and prevent financial crises. Therefore, it suggests that, “Efforts must be focused at trying to ensure that the core of the system is resilient when markets come under stress. Authorities should closely monitor developments affecting core financial firms’ resilience, and focus on incentives that promote institutional and market discipline, using tools under their control.”

“Specifically, supervisors need to sharpen incentives for regulated institutions to improve risk management and stress-testing practices and the adequacy of their capital and liquidity buffers,” it notes. “They must do so in a manner that encourages firms to exercise sound governance practices that result in disciplined risk-taking, without attempting to replace firms’ judgment.”