money funds began to worry about the liquidity of their assets, like asset - backed commercial paper, and when households and businesses tried to use their perceived liquidity, the resulting fire sales accentuated asset price declines and transmitted problems from one sector to another. the initial problems from the excessive risk buildup were exacerbated by the deleveraging that followed, including in the financial sector. although there are many reasons that the deleveraging process has been so painful, one of the defining characteristics has been a sharp increase in uncertainty. uncertainty is an aspect of every crisis, but it escalated to such an extreme degree in the summer of 2007 in response to an unexpected decline in housing prices that the financial system, which had been unusually stable and resilient, was pushed into a zone of increasing instability that in turn triggered an adverse feedback loop between the financial sector and the economy. the views expressed are my own and do not necessarily reflect the views of the other members of the board of governors. matthew pritsker of the board's staff contributed to these remarks. risk had been mispriced, but by how much? who was vulnerable? would the markets and the economy overshoot or return to a more sustainable relationship? financial market participants didn't know the value of assets, the financial health of counterparties, or the likelihood that they themselves would be subject to unexpected hits to their capital or liquidity, for example, from ostensibly off - balance - sheet entities. the result was a hoarding of capital and liquidity, a sharp increase in risk premiums, and a generalized flight to liquidity and safety that only gathered momentum as instabilities in the economy and financial markets fed off each other. the characteristics of the networks and the instruments accentuated the uncertainty. the instruments and the relationships among the institutions had become much more complex and opaque. the complexity of the instruments meant that investors did not understand the risk characteristics of the assets they were buying ; among other problems, they relied on credit rating agencies for due diligence. the complexity of the networks meant that participants did not understand how reliant they had become on a few large core institutions and how those institutions were entwined with each other in very complex ways ; when vulnerabilities started to become evident, market participants became worried about who their counterparties were exposed to. in sum, financiers were taking on more risks than they would like to, and in many respects they did not understand

with more closely tying traders'compensation to the long - run performance of their portfolios. this internalization of the costs of risk - taking toward those most capable of understanding and measuring the risks should help blunt the buildup of excessive risk and leverage. long and complex chains present problems, importantly because of the incentive problems along the chain. nevertheless, there may be sound economic reasons why long chains are desirable. for example, long chains of lending allow for some financial intermediaries to specialize in screening borrowers, others to specialize in arranging initial short - term financing, and others to focus on securitizing the assets and selling them to investors. specialization lends itself to long chains, but such specialization comes with incentive problems at every step of the chain. these incentive problems need to be recognized and dealt with. proposals that require intermediaries along the chain to maintain " more skin in the game " are worth considering, but that approach is not a panacea. many institutions that had skin in the game got into trouble anyway – perhaps because it is hard to judge how much skin is enough to maintain proper incentives. in addition, it may be impossible to police whether an institution has chosen to keep its own skin in the game or whether its risk has been mitigated through hedging. in the end, no one can police the market better than the final investors, provided the instruments are simpler and more transparent. finally, our efforts to stabilize the system by guaranteeing much of the liabilities of systemically important institutions have further distorted the incentives of their counterparties. offsetting the effects of this moral hazard is another reason to hold these institutions to higher standards and find better resolution mechanisms for them. i want to close by reiterating the importance of hyun's contributions. he has led the way in showing that the organization of financial structures is critical to the resiliency of the financial system. going forward, we need to address not just the unstable structures that have become so evident in the recent crisis, but we also need to better understand why these sorts of structures emerge and take steps to prevent their reoccurrence in whatever forms they may take.