That is the price society pays for maturity transformation and the other services provided by the financial sector – services that produce large public benefits. But I doubt that this should be the end of the story – we also have some control over the amplitude of booms and the severity of the busts. Although it is impossible to attribute the instability of financial markets to any one single driving force, recent experience suggests that in many cases innovation plays an important role. I explore this point further in the printed version of my remarks – but for the purposes of our discussion today let me summarize it by saying that innovations that initially create real value generate feedback mechanisms that often fuel the development of excessive expectations – a boom that eventually reverses when the basic belief system that sustained it is contradicted by events. Such innovations can occur in the real economy – consider the Internet – or in the financial sector – think of subprime lending and structured finance products. Although the role of innovation has differed across various booms and busts, some important common elements are evident in many of these episodes. Early on in the cycle, an innovation can lead to changes in fundamental valuations or the creation of new markets and financial products. Examples of this might include the technology boom that followed the creation of the Internet or the subprime lending and the associated structured finance innovations that supported the housing boom.
Second, financial institutions and other market participants need access to high quality information in terms of the financial condition of their counterparties. Balance sheet information including capital and liquidity positions and counterparty exposures would enable financial market participants to more accurately assess the condition of those with which they do business. Increased transparency would reduce the level of uncertainty, which contributes to risk aversion and financial crises. Greater transparency in terms of off balance-sheet activities such as OTC derivatives exposures might also be helpful for the same reasons. Greater transparency is often unpopular because it may reduce market power and reveal business strategies and, thereby, limit profits. But the private loss of profit opportunities must be balanced against the public good of greater financial stability. Such steps reinforce the work underway to make the major financial intermediaries and financial market infrastructures more resistant to shocks when they inevitably occur. This includes appropriate capital and liquidity requirements and appropriate risk management practices for banks and financial market infrastructures. Finally, when institutions do get into difficulty we need a credible way of enabling these institutions to recover or, if recovery is not possible, to be resolved in an orderly manner so that failure of any one institution doesn’t threaten to bring down the rest of the financial system. So how are we doing relative to the agenda that I have laid out? In my opinion, we have made a good start, but there is a long ways to go.