One example of this enhanced impact is provided by the behaviour of hedge funds who customarily borrow short-term funds to finance their (longer-term) investments 9 . -  Turning to the exchange rate channel, financial innovation results in greater integration of domestic and international financial markets, which should also strengthen the exchange rate channel as exchange rates become more sensitive to interest rate differentials between currency areas. This has been illustrated by the recent debate about cross-border carry trades 10 . -  At the same time, financial innovation has probably weakened the credit channel 11 . Several phenomena may be at play : •  Financial innovation gives firms broader access to securities markets, which may reduce information asymmetries at the source of the credit channel. 7  BIS, 1994  8  Noyer, 2001  9  Weber, 2007  10  Weber, 2007  11  BIS, 1994; Thornton, 1994  BIS Review 42/2007  3  •  More specifically, securitisation by banks has reduced their liquidity constraints and thus further weakened the credit channel. A recently published research paper by the New York Fed, using a micro data set of individual loans granted by a sample of banks between 1997 and 2005, shows that the use of credit derivatives is associated with a greater supply of newly negotiated loans extended to large corporate borrowers. Previous research has generally found that banks have used earlier credit market innovations such as loan sales and securitisation to diversify credit risk exposures and increase lending.
This observation, combined with the increased securitization of real estate into diversified national portfolios, gave buyers – and those rating the securitizations – confidence that the “real estate cycle risk” was substantially mitigated through diversification. But, as Figure 7 shows, the assumption that a geographically diversified portfolio of real estate assets would avoid price declines proved wrong. While prices nationally had not experienced a substantial decline in the past, for three years the U.S. has experienced substantial and sustained declines in prices. Some of my colleagues point out, probably appropriately, that given the historical data the failure to anticipate nationwide house prices falling is largely understandable. It was certainly very widespread. What may be more surprising is that in the 2005 timeframe, when many were expecting house prices to slow down or flatten, there was not much by way of risk mitigation undertaken. Myth 2 – Triple-A mortgage securities carried little risk The securitization market – that is, the market for securities based on various slices of pooled mortgages – grew dramatically over the past decade. One reason for the growth in securitization was investor interest in, and demand for, securities with little credit risk but returns above those of Treasuries. Many buyers of such securities felt sure of two things. First, that national real estate prices were quite unlikely to fall – in other words, our Myth 1. Second, that even in the highly unlikely event that the price of a national portfolio did fall, they would be protected by the structure of the securitization.