The IMF says that regulators worldwide need to rethink systemic risk.

In new research, it concludes that both market discipline and regulations failed to keep up with financial market innovation and the buildup of leverage. The IMF’s analysis points to failures at three different levels: regulators that were not equipped to see the risk concentrations and flawed incentives behind the financial innovation boom, policymakers who failed to deal with the growing macroeconomic imbalances that contributed to the buildup of systemic risks in the financial system, and international financial institutions that failed to motivate cooperation at the international level.

“A key failure during the boom was the inability to spot the big picture threat of a growing asset price bubble. Policymakers only focused on their own piece of the puzzle, overlooking the larger problem,” said Reza Moghadam, head of the IMF’s Strategy, Policy and Review Department, in a release.

It also identifies five key weaknesses that need to be fixed: the scope of regulation needs to be expanded to encompass all activities that pose economy-wide risks; market discipline needs to be strengthened; procyclicality in regulation and accounting should be minimized; there needs to be greater transparency in the valuation of complex financial instruments; and central banks should strengthen their frameworks for systemic liquidity provision.

The IMF also points out the role that macroeconomic policies had in the buildup of risks, as investors sought higher returns, fueling demand for the riskier products generated by financial innovation. “At the root of the crisis was the optimism that was brought about by a long period of prosperity. This optimism led to risks in the global economy not being assessed as carefully as they should have been,” Olivier Blanchard, economic counsellor and director of the IMF’s Research Department, said. “With large failures in regulation and supervision, this fuelled high leverage and build-up of risky assets.”

Therefore, it sees a number of lessons for policymakers on the macroeconomic level, concluding that: monetary policy should respond to the buildup of systemic risk, fiscal policy should be put on a stronger footing in good times, and global imbalances must be addressed.

As for international institutions, the IMF finds that action is needed in four areas: policy warnings should be more focused and specific, leadership is needed in responding to systemic global risks, rules for cross-border financial sector resolution are needed to encourage collaboration rather than solutions that minimize the burden on the local taxpayer with potential beggar-thy-neighbor effects, and a credible global liquidity framework is needed.

The IMF admits that implementing its recommendations will be difficult. However, it insists that the sheer scale of the crisis provides clear evidence of the importance of learning from past mistakes. The summit of G-20 leaders on April 2 will be the first opportunity to make real progress, it says.

IE