These challenges exist for all participants in these markets: for the institutions that underwrite, structure and distribute these risks; for those who trade or hold them; and for third parties, like the rating agencies. These challenges of complexity are significant as well because they can exacerbate the problem of dealing with classic principal-agent problems. You can see this in the subprime mortgage market where, for example, a person may be rewarded for generating new mortgages on the basis of volume, without being directly exposed to the consequences of default; but these problems exist wherever incentives diverge and contracting is imperfect. Financial institutions typically maintain a range of different checks and balances to deal with the risk of misaligned incentives: for example, between a trader and the principal whose resources are at risk, or between the mortgage broker or underwriter and the firm that ultimately ends up holding the risk. But these checks and balances depend in part on the capacity of risk managers to observe and understand the underlying economic risk in these instruments. Where that is harder because of this combination of complexity, imbedded leverage, and short loss history, then market discipline will be weaker. A third issue relates to the dynamics of failure and the infrastructure that supports these markets. The dramatic growth in the volume of over-the-counter derivatives and the growth in the number and size of leveraged funds inevitably complicate the resolution of the failure of a large financial institution that is active in these markets.
Timothy F Geithner: Credit markets innovations and their implications Remarks by Mr Timothy F Geithner, President and Chief Executive Officer of the Federal Reserve Bank of New York, at the 2007 Credit Markets Symposium hosted by the Federal Reserve Bank of Richmond, Charlotte, North Carolina, 23 March 2007. *  *  *  I am grateful to Jeff Lacker for including me in this conference, and my compliments to him and the Richmond Fed for bringing together an excellent group to discuss the implications of recent innovations in credit markets. The past few years have seen remarkable changes in credit markets, and this is a good time to take stock of what we know about those developments and their implications. The latest wave of credit market innovations has elicited some concerns about their implications for the stability of the financial system, concerns similar to those associated with earlier periods of rapid change in financial markets. Will the most recent credit market innovations amplify credit cycles, contributing to "excessive" lending in times of relative stability, and then magnify the contraction in credit that follows? Will they introduce greater volatility in financial markets? Will they create greater risk of systemic financial crisis? These concerns have been heightened in some quarters by the problems currently being experienced in the subprime mortgage sector. It will take some time before the full implications are understood and the full impact can be assessed.