As of now, though, there are few signs that the disruptions in this one sector of the credit markets will have a lasting impact on credit markets as a whole. Indeed, economic theory and recent practical experience offer some reassurance against both these specific concerns and more general worries about the implications of credit market innovations for the performance of the financial system. The rapid growth in these new types of credit instruments is, of course, a sign of their value to market participants. For borrowers, credit market innovation offers the prospect of increased credit supply; better pricing; and a relaxation of financial constraints. For investors, new credit instruments bring the prospect of broader risk and return opportunities; the ability to diversify portfolios; and increased flexibility. And for lenders, innovations can help free up funding and capital for other uses; they can help improve credit risk and asset/liability management; and they can improve the return on capital and provide new and cheaper funding sources. By spreading risk more broadly, providing opportunities to manage and hedge risk, and making it possible to trade and price credit risk, credit market innovation should help make markets both more efficient and more resilient. They should help make markets better able to allocate capital to its highest return and better able to absorb stress. Broad, deep and well-functioning capital markets complemented by strong, well-capitalized banks, able to provide liquidity in times of strain, make for a more efficient financial system: one which contributes to better economic growth outcomes over time.

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.