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Financial Engineering: The Evolution of a Profession by Cara M. Marshall, Tanya Beder

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Chapter 29

Influencing Financial Innovation: The Management of Systemic Risks and the Role of the Public Sector

Todd Groome*

Alternative Investment Management Association

John Kiff and Paul Mills

International Monetary Fund

INTRODUCTION

This chapter discusses the limits to market-based risk transfer and risk mitigation instruments, and the implications for the management of systemic long-term risks. Instruments or markets to transfer and better manage such risks across institutions and sectors are, as yet, either nascent or nonexistent. As such, the chapter investigates why these markets remain incomplete. It also explores a range of options by which policy makers may encourage financial innovation and the development of markets as part of governments’ broader role as a risk manager.

We start by showing that, while financial markets have demonstrated significant innovation regarding the management of a variety of nontraditional risks, little activity is occurring with regard to some of the most significant longer-term risks. However, we show that some innovations may provide the building blocks for further advances in risk management instruments and markets. In addition, we discuss the important structural impediments to further growth in the size and scope of certain markets, including data availability, regulatory frameworks, rating agency treatment, tax and accounting policies, and market structure.

We next outline the principal long-term systemic risks, focusing on certain ...

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