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AbstractThis study introduces a general approach to investigate resource allocation and asset prices in an economy with uncertainty and shifts in market sentiment. The approach presents a number of key features: first, it proposes a choice‐theoretic model that determines the utility that the agents derive from holding assets with different liquidity. Second, it incorporates a variable (endogenously‐determined) cost structure of asset liquidation, which reflects the (in)efficiencies of the financial infrastructure and changes in market moods. Third, it also incorporates a model of expectations formation under uncertainty and changing market sentiment. While rich in structure, the approach offers a simple analytical framework to investigate resource allocation decision and asset price dynamics under various sources of uncertainty, and to explore the micro‐economics of speculative bubbles and boom–bust sequences. The use of a possible market‐specific prudential policy tool is discussed.

In this brief, Biagio Bossone of the International Monetary Fund evaluates narrow banking from the perspective of modern theories of financial intermediation. These theories portray the status quo banking system as a solution to otherwise intractable problems of imperfect information, risk, and even moral hazard. The system's characteristic coupling of liquid liabilities with illiquid assets - seen by some as an undesirable mismatch - in fact contributes greatly to the efficiency of the economy. Bossone argues that these efficiency gains outweigh the disadvantages associated with the existing legal framework.

An international cooperative effort has been focused on the need to reduce financial fragility and systemic risks in global financial markets. Work is proceeding in three different areas: enhancing financial market transparency, improving the international financial architecture, and strengthening financial systems. Strengthening financial systems (the focus of this paper) means cooperating to promote principles and sound practices for financial stability through development of well-functioning financial systems and market discipline. Financial sector reform and development is much more than setting rules, articulating standards, approving legislation, and creating new institutions. All are important but ultimately behavior must be changed if there is to be meaningful and lasting financial reform. For that reason, this paper emphasizes the role of incentives to induce appropriate behavior. Developing countries have made important progress toward improved financial supervision in the past few years. Reforming financial sectors is a lengthy and complex process of institution building and incentive reorientation, whose success requires full ownership of, and participation in, the process by society and its government.

Coping with the challenges of global economic governance is a topical issue of the current international agenda, and the object of a vivid debate among scholars and policy-makers. The international financial and economic crisis that erupted in 2007 reveals the fallibility of the neoliberal paradigm that has dominated the world economic landscape for the last quarter of a century; regulatory and supervisory institutions have disclosed their weaknesses, and markets have shown their limits in de