financial development can be characterized as a process in which innovation tends to lead to improvements in the quality of information, and this, in turn, enables new financial products and markets to develop. indeed, in the past decade or so, technological innovations and financial market liberalization improved the flow of information and capital to broader groups of people. for example, the microfinance revolution in developing countries has made capital available to many poor, small entrepreneurs. in the united states, financial innovation has recently manifested itself partly in the development of the market for subprime mortgages. while that market had serious weaknesses that eventually imposed large costs on many borrowers and their communities, it also brought considerable benefits to many others who were able to take advantage of responsible products never before available. as a david bowman, fang cai, linda kole, michael palumbo, and dan sichel, members of the board's staff, contributed to the preparation of these remarks. the views expressed are my own and do not necessarily represent the views of other members of the board or the federal open market committee. result, they found themselves far better off financially than they probably would have been otherwise. as this recent experience suggests, financial liberalization and innovation bring many benefits but can also create information and incentive problems that lead to mistakes. when mistakes of this nature become evident, financial markets can seize up, with potentially significant adverse consequences for the economy. advances in information technology and financial innovations in recent decades encouraged new lending products and faster securitization of debt. this lowered transaction costs and contributed to a " democratization of credit " – that is, the extension of credit to a wider spectrum of possible borrowers than in the past. in the united states, a potential customer with an internet connection could quickly fill out an online form, and a mortgage broker could rapidly price a loan with the help of credit - scoring technology. the resulting mortgages were bundled together to produce mortgage - backed securities, which could then be sold off to investors. advances in financial engineering took the securitization process even further by carving mortgage - backed securities into more - complicated structured products, such as collateralized debt obligations ( cdos ), or even cdos of cdos, with an eye to tailoring the credit risks of various types of assets to risk profiles desired by different kinds of investors. all seemed well as long as the economy – particularly, the housing market – was booming, and credit became more and more available. but when

should they occur, will be a more expansionary fiscal policy. moreover, monetary policy has been and will continue to be responsive to rapidly changing circumstances. all told, as you know, we have taken the federal funds rate down 100 basis points since september 11, in two steps of 50 basis points each. it is too soon to judge the strength of these various forces - - consumer and business behavior, monetary and fiscal policy - - and how they will balance out. risk modeling : benefits and critiques let me turn now to the theme of this conference. risk management, as this audience is very well aware, has been revolutionized in recent years by advances in both theory and technology. this morning, i would like to discuss the nature of better risk management and also some observers ’ criticism that the expanded use of sophisticated techniques for measuring and managing risk may actually increase market volatility and reduce market liquidity. for centuries, financial intermediaries - - lenders, institutional investors, dealers, and insurers - - have engaged in risk modeling. the model was in their heads and was based on judgment and experience, but that model involved categorizing and evaluating the proposed risk and reaching a series of interrelated decisions. for example, in the context of bank lending, for each potential credit those decisions have included : ( 1 ) whether or not to lend, ( 2 ) at what price to lend, ( 3 ) what maturity should the loan have, and ( 4 ) what collateral to accept and how to structure it. formal models for market and credit risk are designed to augment judgment and experience to help make exactly the same decisions. the difference, of course, is that models rely on a clearly specified base of information and do so in a structured way. judgment is still required in determining inputs and evaluating outputs, but the modeling process was inconceivable before the development of both modern finance theory and modern information technology. and, in my opinion, by measuring and managing risk in a formal and structured way, models, when combined with sound judgment, have, on balance, improved the resultant decisions. what have been the benefits of the new model - based approach to risk measurement and management? the most important is that better risk measurement and management contribute to more - efficient resource allocation. when risk is better evaluated, it can be more accurately priced ; if it can be more - accurately priced, it can be more easily spread among a larger number of market participants, improving