7  My colleague Ben Broadbent has noted that the difficult-to-reverse nature of investment projects creates an option value of waiting which increases with uncertainty leading firms to require projects not just to cover the initial cost but to do so by a wide margin. See 'Uncertain Times', Speech given by Ben Broadbent, Deputy Governor, Monetary Policy at the Wall Street Journal, The News Building, London. October 2016, available at: http://www.bankofengland.co.uk/publications/Pages/speeches/2016/929.aspx. 8 Eg, Gilchrist, Sim and Zakrajsek (2014), 'Uncertainty, financial frictions, and investment dynamics', NBER WP 20038 and Christiano, Motti, Rostagno (2014), 'Risk shocks', American Economic Review 104(1), 27-65). 12  All speeches are available online at www.bankofengland.co.uk/speeches  12  Risk aversion was cited as an obstacle by 70% of the underinvesting firms. This may be due to 'scarring effects' from the crisis which markedly lowered returns from investment in 2009 and increased the cost of finance. Interestingly, nearly 40% of firms in the survey had a hurdle rate above the rate of return they had experienced on investment in the past five years, suggesting perhaps that for many firms investment has not met expectations. Such experiences may have increased both risk aversion and uncertainty. This would be consistent with other more general studies documenting enduring risk aversion (or scarring). 9  Academic literature suggests that experience of adverse events can affect future risk-taking behaviour. There is evidence that individuals who experienced the Great Depression reported lower willingness to take financial risk throughout their lives.

During the crisis, some examples of bad incentives that sustained the boom included: 2/7  BIS central bankers' speeches  1. Compensation practices at financial firms that rewarded volume and short-term performance over longer-term, sustainable returns; 2. The conflict of interest inherent in the willingness of the credit rating agencies to designate tranches of subprime mortgages triple-A in exchange for fees; 3. The ability of Fannie Mae and Freddie Mac to use their implicit government support to take on large amounts of mortgage risk with very little capital backing; and, 4. The ability of AIG to use its triple-A rating to provide credit protection to banks and securities firms against complex mortgage obligations with little direct capital support or an adequate liquidity backstop. Culmination of the crisis Once the housing bust got underway, stress on the financial system increased sharply as asset prices fell and bank earnings plunged. In the spring of 2008, such pressures led to a forced sale of Bear Stearns to JPMorgan Chase. Later in the year, the government placed Fannie Mae and Freddie Mac into conservatorship. In September, Lehman Brothers failed. And, a day later, AIG was rescued in order to protect the rest of the financial system against further losses and even broader contagion. With confidence in financial markets and financial intermediaries badly frayed, the Federal Reserve and the U.S. government intervened and provided a range of liquidity backstops, debt guarantees, and capital infusions to forestall a complete collapse of the financial system and the economy.