More participants are thereby given the opportunity to invest in assets that have largely been reserved for financial institutions. Banks are also provided with increased possibilities to diversify the risk in their loan portfolios across different sectors and regions. All in all, this contributes to spreading the credit risk linked to the loans. When risk is diversified, the financial system is less vulnerable in the face of financial turbulence. b)  Continuous pricing of risk reduces the possibility of shocks  Loans from financial institutions and securities debt differ widely in terms of the degree of transparency in credit rating and pricing. The credit rating in financial institutions must be looked upon as internal company information. Loans provided by banks and financial institutions are far less liquid than negotiable securities and the price will generally not change as a result of new information about the borrower. On the other hand, securities markets are subject to transparency and information requirements. Participants’ credit ratings are continuously reflected in the transparent pricing process in the market. The stability in our financial system is strengthened when market operators’ assessment of the correct value is reflected transparently and continuously in prices. A precondition is of course that the information that companies are obliged to provide is correct. Economic shocks will also be more easily absorbed, even though considerable price changes may have substantial wealth effects. Because banks lend at relatively fixed rates, financial institutions must be able to adjust volumes when new information is available.

5 Third, some of the assumptions on which financial activity has been predicated turn out to be (or are seen as being) invalidated; eg, in the current  5  Ingves S, “A Cure for Crises: Confidence, Confidence and Trust”, a speech at the Eurofi Forum, Gottenburg, September 2009. Akerlof, George A, 1970 “The market for ‘Lemons’ Quality Uncertainty and the Market Mechanism”, The Quarterly Journal of Economics, MIT Press, vol 84 (3), pp 488-500, August. BIS Review 134/2009  5  crisis, the reliability of ratings of ABS. Fourth, the demand for liquidity rises, and its supply falls back. Markets become less liquid. Rising liquidity premia and forced sales depress asset values. Credit supply is reined in. A vicious circle is threatened by the excess leverage and liquidity mismatch that have developed in the financial system during the upswing. During that upswing, important contributory factors will typically have included illusions about risk-adjusted returns; underestimating the extent to which buoyant conditions are being driven by falling liquidity premia; and a sense that, if the bubble bursts, the central bank will somehow be able to contain the spillovers. This amounts to “risk illusion”, which should probably be as much debated as “money illusion” is in monetary economics. Separately, there is a potent collective action problem in getting off the dance floor. Not a few senior market participants felt from at least 2006 that financial risk was underpriced, and that conditions in, for example, the leveraged loan market were silly.