There were manifest conflicts of interest, originators and brokers had limited interest in ensuring continued monitoring of products and credit ratings were inflated, conveying a false sense of security. A euphoric bubble thus developed, based, in Alan Greenspan’s words, on “the complexity of the interactions of asset markets and the economy”, and which concealed a massive global under-pricing of risk. Market participants seem to have been aware of the growing risks but were unwilling to retrench. You might recall Citibank’s Chuck Prince’s memorable words during the onset of the crisis that “as long as the music is playing, you’ve got to get up and dance. We’re still dancing”. Market players failed to appreciate the speed at which demand could evaporate and risk aversion could increase. This soon resulted in record-high risk premia, seized-up interbank markets, acute liquidity and credit shortages, bank failures and a widespread loss of confidence. Meanwhile the high degree of financial market integration had created the premise for a simultaneous build-up of systemic risk. Financial institutions did not internalise the costs arising from the too-big-to-fail and too-interconnected syndrome. Central banks had been monitoring these trends, but it turned out that the regulatory tools were not designed to address systemic risk. Neither was the strength of the feedback loop between the financial  BIS Review 67/2010  1  system and the economy fully anticipated. Unfortunately, these all proved to be critical weaknesses.
There are fewer of the pegged exchange rate regimes that often came violently undone during past periods of acute market stress. Monetary policy regimes are generally better structured and more coherent. Banking systems are better capitalized and supported by stronger regulatory and supervisory frameworks. Foreign exchange reserve cushions are larger and generally still ample. I think we can remain cautiously optimistic about EMEs’ prospects overall in the years ahead, although particular countries will face considerable challenges over the near term. How will we at the Fed take in and respond to these developments? As I’ve already noted, foreign developments factor into our assessment of the U.S. outlook. Recent FOMC statements have sometimes made this connection explicit, noting that the Committee will be monitoring foreign economic and financial conditions closely. The weakness we have been seeing in EME economies and markets is one of the considerations behind the Committee’s assessment that the appropriate pace of policy normalization is likely to be gradual. The federal funds rate is only one element of the broader set of financial conditions affecting the U.S. growth and inflation outlook. Tighter financial conditions abroad do spill back into the U.S. economy, and policymakers must take this into account in their assessment of appropriate monetary policy. Of course, this does not mean that we will let market volatility dictate our policy stance.