as i have argued elsewhere, 2 this function of financial markets is critical to a well - functioning economy ; without it, countries, and their populations, cannot get rich. enabling financial markets to effectively perform this essential function is by no means easy ; financial markets must solve information problems to ensure that funds actually go to those with productive investments, so that they can pay back those who have lent to them. financial development involves innovations or liberalization of financial markets that improve i thank andreas lehnert for his excellent assistance and helpful comments. my remarks reflect only my own views and are not intended to reflect those of the federal open market committee or of anyone else associated with the federal reserve system. frederic s. mishkin ( 2006 ), the next great globalization : how disadvantaged nations can harness their financial systems to get rich, princeton : princeton university press. the flow of information. unfortunately, however, financial liberalization and innovation, often have flaws and do not solve information problems as well as markets may have hoped they would. when these flaws become evident, financial markets sometimes seize up, often with very negative consequences for the economy. i would argue that we have been experiencing exactly such a cycle in recent years. advances in information and communications technology have allowed for faster and more disaggregated mortgage underwriting decisions. a mortgage broker with an internet connection could quickly fill out an online form and price a loan for a customer with the help of credit - scoring technology. the same technological improvements would allow the resulting loan to be cheaply bundled with other mortgages to produce mortgage - backed securities, which could then be sold off to investors. advances in financial engineering could take the securitization process even further by aggregating slices of mortgage - backed securities into more complicated structured products, such as collateralized debt obligations ( cdos ), to tailor the credit risks of various types of assets to risk profiles desired by different kinds of investors. as has been true of many financial innovations in the past, the benefits of this disaggregated originate - to - distribute model may have been obvious, but the problems less so. the originate - to - distribute model, unfortunately, created some severe incentive problems, which are referred to as principal - agent problems, or more simply as agency problems, in which the agent ( the originator of the loans ) did not have the incentives to act fully in the interest of the principal ( the ultimate holder of the loan ). originators had every incentive to

a negative feedback loop, with the problems of one feeding on those of the other. to break out of this loop, elements of a banking union are currently being discussed. these elements need to be considered together and seen in the light of the trade - off between insurance and incentives. the first element of the banking reform is the creation of a single supervisory mechanism involving the ecb. besides the obvious coordination and information benefits for supervising banking in a financially integrated area, and given the risk of regulatory capture when the supervisor and the supervised are too close to each other, partially transferring supervisory authority up one level can be seen as a commitment not to renegotiate. it limits regulatory forbearance ( a form of insurance ) and serves as an incentive for sound risk management in the banking sector. it also ensures the singleness of banks ’ liabilities in the euro area, congruent with the single monetary policy. within the ecb, there should be a strict separation between the single supervisory mechanism and monetary policy, as a way to safeguard incentives when liquidity is extended. to quote bagehot once again : “ any aid to a present bad bank is the surest mode of preventing the establishment of a future good bank. ” 1991 ; and d. diamond and r. rajan, “ liquidity risk, liquidity creation, and financial fragility : a theory of banking, ” journal of political economy, 2001. see w. bagehot ( 1873 ), lombard street : a description of the money market, henry s. king and co. see t. sargent and n. wallace, “ some unpleasant monetarist arithmetic ”, federal reserve bank of minneapolis quarterly review, fall 1981, pp. 1 – 17. see w. bagehot ( 1873 ), op. cit. bis central bankers ’ speeches once incentives are upheld, it is possible and desirable to provide insurance. incentive - compatible insurance must, however, be partial. and that is why it is important to add other elements to complement the single supervisory mechanism. one such element is a european resolution mechanism. since a bank ’ s debt should not be insured in full, it should, and in fact will, be possible for banks to fail. since the beginning of the financial crisis in august 2007, the federal deposit insurance corporation ( fdic ) lists 466 cases in which banks in the united states failed. given the special role of banks as intermediaries, the failure of one bank