Furthermore, economies with flexible interest and exchange rates are able to accommodate external shocks more easily than those under rigid price regimes, where adjustment relies heavily on quantity changes, including higher unemployment. Fourth, financial markets frequently suffer from imperfections, such as asymmetric information, adverse selection, and moral hazard, which can translate into negative externalities to the rest of the economy.
The financial system is based on trust and the management of risk. When risk is not appropriately priced, contagion may arise and trust may be jeopardized. These limitations make adequate regulation and supervision absolutely necessary. While the rules of the game should provide the correct incentives to market participants, by reducing moral hazard for example, prudential policies should aim at preventing systemic crises.