There are therefore compelling arguments in favor of a generally positive assessment of the consequences of innovation. Does experience provide support for these arguments, or are these changes too new for us to know? The recent changes in credit markets have been dramatic. We have seen rapid growth of structured credit products, credit default swaps and new types of collateralized debt and loan obligations. Although these instruments are very new, they are the natural extension of earlier innovations in credit markets. Over a long period we have seen innovations ranging from the syndication of bank loans and the direct provision of credit through the capital markets, to the spread of asset-backed securities and products that separate different parts of the payments stream and different dimensions of the risk in a credit obligation into different instruments. These changes have contributed to a substantial reduction in the share of total credit held by banks. They have produced a greater separation or distance between the entity that first arranges a loan and those who end up holding the risk, and more intermediaries in that chain. And they have contributed to a dramatic increase in the number and diversity of creditors to any individual borrower, and a greater capacity to actively trade credit risk. BIS Review 29/2007  1  We are now well into the third decade of experience with the consequences of these earlier innovations, and this history offers some useful lessons for evaluating the probable impact of the latest changes in credit markets.
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.