Much has been discussed on the root causes for the current financial crisis, including but not limited to lessons on monetary policy, financial sector regulations, accounting rules. This note aims to stimulate debate and discussions on some of the pro-cyclical features in the system, possible remedial measures, and how monetary and fiscal authorities can play their professional roles at times of severe market distress. It also touches upon China's financial sector reform and macroeconomic policy to counter slowdown in economic growth. The major points here were presented at the G20 Meeting of Finance Ministers and Central Bank Governors in San Paulo, Brazil on November 15, 2008.

1. The built-in pro-cyclical features in financial architecture

When we discuss system stability, we can borrow some concepts from electronic engineering or control theory. In a complicated system, there are usually many feedback loops, some of them are positive, some of them are negative. A positive (plus) feedback loop enlarges amplification (like multiplier), tends to create oscillation (like boom and bust pro-cyclicality) and zero-point shifting (like a reference of bubble). While a negative (minus) feedback loop can reduce amplification, help for system stability and self-correction of zero-point. In economic and financial systems of recent years, we have too many positive feedback loops on macro and micro levels, and a small number of negative feedback loops. Thus the system shows a strong pro-cyclicality. What we need to do is not to totally rebuild the system, but to add a few negative feedback loops, which are able to sufficiently change the characteristics of our system.

Financial crises normally originate in the accumulation of bubbles and their subsequent bursts. Usually, economists pay a lot of attentions to pro-cyclicality on the macro level. However, on the micro level, there are quite a number of notable pro-cyclical features embedded in the market structure today, which should be addressed as we deal with the current crisis and reform the financial system. In the current market structure, more counter-cyclical mechanisms or negative feedback loops on micro-level should be put in place to sustain a more stable financial system.

1) Rating problems and herding phenomenon arising from outsourcing

The global financial system relies heavily on the external credit ratings for investment decisions and risk management, giving rise to a prominent feature of pro-cyclicality. The rating industry is dominated by a few large players, which provide practically all important rating services. Specific ratings from the big three tend to be highly correlated and they are combined to form a strong cyclical force. Economic upswings produce euphoria and downturns generate pessimism. Many market players adopting ratings from the three agencies and using them as the yardstick for operations and internal performance assessments clearly result in a massive "herd behavior" at the institutional level. Moreover, the rating process is filled with conflicts of interest by virtue of the issuer-paying business model (issuers also pay for the rating agencies' advisory services on structuring their products, which leads to more problems). Moreover, the rating models for mortgage-related structured products are fundamentally flawed. During the current crisis stemming from the subprime mess, the high ratings assigned to many subprime products and the massive downgrades of them within short period were unprecedented, which drove the massive write-downs by financial institutions, and exacerbated downward spirals.