It is shocking to me to see how quickly market participants have forgotten how severe the financial travail in the United States was just at the start of this decade-the failure of many thrift institutions, the near failure of several prominent commercial banks, and the restraint on many business corporations and real estate developers from overleveraging.

Internationally, we need not go back to the pervasive economic and financial dislocations and calamities that occurred when oil prices rose sharply in the 1970s. Just a few years ago financial mismanagement in Mexico brought that country to its knees.

Some years ago I expressed the concern that we are moving into a financial world where credit has no guardian. That is even more true today. This drift needs to be arrested. Let us begin by asking about the lessons market participants should have learned from the latest financial turmoil, and then asking how we limit financial excesses in the future.

From my perspective, there are at least 13 lessons.

Lesson 1. Good times breed the illusion of boundless financial liquidity. Markets that grew up during the happy days of escalating equity prices, modest yield spreads relative to U.S.-governments, and skinny bid/offer spreads do not provide boundless liquidity in more turbulent times.

Lesson 2. Marketability is not the same as liquidity. Securitizing financial assets gives the false impression of seamless marketability. Market activity, however, varies considerably over a financial cycle. Consider how easy it was to distribute new large blocks of Russian bonds earlier this year and how difficult it is to disgorge them from portfolios without making huge price concessions.

Lesson 3. Marking financial assets to market is an imperfect process. In difficult markets, it overstates values and provides false comfort. Can one really claim that the last quoted price in organized markets or those quoted by dealers is the real market value without taking into consideration such aspects as size, credit quality, and general market conditions?

Lesson 4. Modeling risk has great limitations. Mathematics allows exquisite refinement of history but is useless when the underlying structure changes. One of the key structural changes is the loss of liquidity. Models that provide good formulas for conducting dynamic hedging under normal circumstances are of no assistance when transactions cannot be made without huge price concessions.

Lesson 5. Contagion is a major force in the modern globalized, securitized system. The rush to shed risk spared no segment of the fixed- income markets. It was certainly not limited to the emerging debt markets. Very high-grade markets rally dramatically, and lower-quality markets set back dramatically.

Lesson 6. International diversification fails to provide much protection to the investor. This was true in 1982. It was true again in 1994-5. It has been true in the past year. The arithmetic that purportedly proves that diversification lowers portfolio risk assumes normal covariances, which go out the window in periods of contagion.

Lesson 7. Even lightly leveraged market participants lose access to position financing in disorderly markets. This was particularly acute in the emerging debt markets. The lesson is that investors cannot count on normal business relationships with dealers when conditions turn turbulent.

Lesson 8. Investors cannot rely on sell-side analysts to alert them to bad news. They can't rely on government, IMF, or World Bank staffs either.

The answer, of course, is that investors have to do their own research, but that is difficult because of the pathetic quality of much of the data provided by the governments of emerging countries.

Lesson 9. Ratings agencies are not timely in their analysis. They were overly generous almost until the last second.

Because high ratings put the Asian countries' dollar debt in the standard bond indexes, indexers, who do no independent credit evaluation, had to own the paper.

Once the ratings were cut, they had no alternative but to sell, magnifying the collapse in asset values in the secondary market and making it that much more difficult to issue bonds.

But once they began to sell, the ratings agencies took the widening in yield spreads as a sign that the situation was deteriorating further. So they continued to downgrade the credits, even after IMF programs were in place.

Lesson 10. What is off balance sheets is perhaps as important as what is on balance sheets. This is only logical; when leverage is generated off- balance-sheet, the standard accounting numbers don't begin to describe the full extent of exposures. Korea, for example, was supposed to have had over $30 billion in reserves when its problems began, but these reserves disappeared quickly because of outstanding commitments in the forward market.

More recently, Long Term Capital Management was reported to have had historical commitments in the derivatives market of about $1.4 trillion that dwarfed the data reported on its conventional balance sheet.

Lesson 11. At times of turmoil, market participants can't rely on netting the plus positions and minus positions with clients. Thus gross exposures may be the true exposures.

(An interesting test is the setoffs that Lehman Brothers is seeking to enforce on its positions with various Russian counterparties. This may provide a significant legal test of whether netting is available.)

Lesson 12. Securitization does not eliminate the important role of commercial banks in the buildup of risks.

The Japanese, European, and American banks which had increased their short-term lending in Asia vastly magnified the risks to bond investors, most of whom had acquired their bond holdings at a time when bank lending was mostly subdued.

They figured that the bankers were out of the business and would not return. This assumption proved wrong. Despite the sorry experience of the 1980s, the bankers believed that short-term loans could be securitized at will, because the ratings were so high. None foresaw obstacles to funding risks, which then would lead to lowered ratings.

Lesson 13. When default looms, securitization shifts power away from investors and toward borrowers-even more than years ago, when commercial banks dominated.

This was dramatically revealed in the case of Russia. Securitization meant that collectively lenders had less clout once conditions went badly wrong in August. The Russian government successfully (up to now, anyway) was able to exploit that mismatch of negotiating position by unilateral repudiation.

With these lessons in mind, there are two broad approaches to dealing with financial excesses. There is the approach of the financial conservative, who favors the status quo and stresses traditional values of prudence, safety and soundness. There is also the approach of the financial liberal or entrepreneur, who emphasizes the more modern values of market efficiency, profitability, and expanded choice.

Taken to an extreme, financial conservatism has the potential to stifle economic growth as well as social invigoration and renewal. Ultimately, a society overly dominated by financial conservatism will pay a price. It may dull the aspirations of risk-takers and ultimately harm economic democracy.

However, financial entrepreneurship is prone to go to extremes as well. Excesses of financial entrepreneurship often lead to serious abuses-either reckless lending, exploitation of the public safety net, or playing roughshod with the law or financial morality. These abuses weaken the nation's financial structure and undermine public confidence in those involved in financial life.

I do not favor a financial system that is straitjacketed with overregulation. However, one where credit has no guardian is also undesirable. We can, however, have a system where highly excessive financial behavior is not tolerated. The prerequisite is to improve supervision and accountability for major markets and institutions. Because markets now function way beyond national borders, such supervision and accountability must have a global reach.

This is why I have suggested for some time now the creation of a new official international institution, a Board of Overseers of Major Financial Markets and Institutions.

I was delighted to see that just within the past few months a world financial regulator was proposed by Prime Minister Blair of England; a new surveillance mechanism was favored by Paul Martin, the Canadian Finance Minister; and even our government belatedly favors a new international architecture.

I do not favor an intrusive new institution, but rather one that among other things sets minimum capital requirements and uniform reporting, accounting, and trading standards for all major institutions. The IMF cannot perform this function efficiently. Its role should revert back to being a lender of last resort for countries with temporary balance of payment problems.

Concurrently, monetary policy must also meet the challenges of this new dynamic financial world. The Federal Reserve continues to set target ranges for the rates of growth of several definitions of the money supply, but it goes to great lengths to assert that it doesn't take the targets very seriously, because old relationships between money and the rest of the economy have become entirely unreliable.

That is true also for measures of credit. Securitization is associated with a diminished role of depository institutions in the intermediation of credit flows, and so debt aggregates are just as unreliable as monetary aggregates.

Belatedly, wealth effects from the movement of financial assets are now being recognized as an important influence on economic activity. However, there is no mandate at the present time for any central bank to explicitly consider financial asset prices in the formation of monetary policy.

Indeed, an asymmetrical market attitude seems to prevail. Market participants are saying to the Fed, "Don't interfere when stock prices are rising and markets are bubbling, but rescue us quickly when financial frailties are exposed."

Continued adherence to such a policy approach will build into the system very dangerous market biases and even greater excesses. But eliminating such biases by the Fed requires a monetary fortitude and wisdom that has yet to be demonstrated.

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