. moreover, both borrowers and lenders badly mispriced and misunderstood risks, which often became embedded in new, complex, financial instruments. neither was protected against a substantial decline in the price of houses. and that mispricing was not just confined to the housing sector. compensation for risk was too low across a broad array of credits. ironically, an important contributor to these misalignments in spending and lending was the long period of economic expansion and low inflation over the past 25 years, interrupted only a few times by mild recession. this good economic performance provided skewed data and bred complacency : house prices could only go up ; income interruptions and problems servicing debt were likely to be short lived ; financial markets would always be liquid. models based on theory and estimated with data from the 1990s and early 2000s fit well – too well. complacency, in turn, contributed to the unwillingness of many financial market participants to enhance their risk - management systems sufficiently to take full account of the new ( perhaps unknown ) risks they were taking on. in this environment, financial institutions stretched the amount of capital they were holding, building leverage. with better models, sophisticated contracts, and the belief that risks had been distributed more efficiently, many market participants believed that less capital was needed. because the amount of capital held by financial institutions on their balance sheets was so small, productivity in the financial sector looked as though it had increased dramatically when the amount of securitization and other off - balance - sheet activities ( for example, derivatives ) increased. but many of those off - balance - sheet instruments came back onto the balance sheet when markets started to seize up. finally, many market participants also had inadequate liquidity backstops, apparently because they ( wrongly ) assumed that markets would be sufficiently liquid to smoothly adjust risk profiles to new developments in markets and the broader economy. thus, capital and liquidity cushions fell short of what was needed for the complexity of instruments that were created, for the funding risks being incurred, and for the broad array of market and other risks to the firms and to the financial system more generally. systemic risk is an externality that results from exposures that cannot be diversified away. the financial turmoil that we have been experiencing for more than a year originated in the market for subprime mortgages, in which the combination of falling house prices and poor underwriting standards triggered a rapid rise in delinquencies. multilayered securiti

donald l kohn : productivity and innovation in financial services speech by mr donald l kohn, vice chairman of the board of governors of the us federal reserve system, at the official celebration of the 10th anniversary of the central bank of luxembourg, luxembourg, 12 november 2008. * * * i am pleased to participate in this panel discussion on the importance of the growth and productivity of the financial sector for monetary policy. i am certain that when the european money and finance forum and the central bank of luxembourg planned their conference, they did not imagine how significant the topic would be. 1 we are in the midst of very difficult times for world financial markets and economies. over the past several decades, we witnessed a rapid expansion of financial intermediation and financial instruments around the globe. we always understood that the new financial relationships were substantially influencing the characteristics of economic activity – especially in recent years, u. s. mortgage markets and residential construction, in particular, and household borrowing and spending more generally. unfortunately, that long period of innovation and heightened financial activity exploded into an unsustainable credit boom that was marked by a failure to appropriately evaluate risks in lending to households and businesses, excessive leverage by both borrowers and lenders, and increased reliance on complex and opaque financial instruments that were poorly understood and fragile under stress. the resulting financial strains and severity of their effects on real activity have clearly shown the limits of our ability to anticipate how and where problems in the financial sector would emerge and of our understanding of the channels through which the financial stresses could lead to a broad - based pullback in lending and adverse spillovers into the real economy. the recent experience has also underscored the difficulties associated with measuring financial services and the productivity of financial firms. the financial sector and economic activity banks and other financial institutions allocate credit. at the most fundamental level, they take savings from the household sector and elsewhere and lend it to firms, households, and governments that want to borrow to spend. in the best circumstances, the operation of financial markets is transparent to the macroeconomy. the financial system allocates credit efficiently to firms that invest in capital resources that improve the productivity of other inputs ( for example, labor ) and contribute to the growth of the economy. the financial system also offers households choices about how they allocate consumption over time. financial institutions can be viewed as reducing information asymmetries that impede borrowers ’ access to credit, and they provide transaction services to borrow