loan officers may sometimes ignore valuable private information in order to mimic others when their own evaluation, their own remuneration or their own external reputation depends on their performance relative to the rest of the market. 9 this behaviour is individually rational but socially wasteful. here at the university of cambridge, the famous analogy that john maynard keynes made between newspaper beauty contests and financial market behaviour comes to mind. 10 i am also convinced that one of the main reasons behind herd behaviour in financial markets in general, particularly in times of crisis, is a lack of transparency. the fostering of transparency as concerns financial institutions, financial markets and financial products is therefore one essential policy lesson from the present crisis. our latest experience with systemic risk let me now apply the relevant elements of this framework on how to think about systemic risk to the present crisis. a particularly relevant source of systemic risk was the build - up of widespread financial imbalances – the second form of systemic risk i described – in the period of 2003 to 2007. the years prior to 2007 were characterised by low financial market volatility and risk premia, rapid financial innovation in credit markets, low interest rates across the maturity spectrum and ample liquidity conditions. in particular, rapid financial innovation led to securitisation techniques with thus far unknown complexities and to long and uncontrollable chains of intermediaries between originators and final investors. ratings agencies gained global power as the pricing of securitisation tranches was largely based on their assessment, while leverage mounted ever higher and a shadow banking system developed up largely unregulated. for a recent example, see o. castren and i. kavonius ( 2009 ), who study non - linear adjustments in a riskbased network of exposures based on euro area flow of funds data ( “ balance sheet interlinkages and macrofinancial risk analysis in the euro area ”, ecb working paper, no. 1124, december ). scharfstein, d., and j. stein ( 1990 ), “ herd behaviour and investment ”, american economic review. he noted that competitors did not have to pick “ those faces, which he himself finds prettiest, but those that he thinks likeliest to catch the fancy of the other competitors ” ( keynes, j. m. ( 1936 ), “ the general theory of employment, interest and money ”, macmillan cambridge university press ). at the same time, mark - to - market accounting rules

jean - claude trichet : systemic risk text of the clare distinguished lecture in economics and public policy by mr jean - claude trichet, president of the european central bank, organised by clare college, university of cambridge, cambridge, 10 december 2009. * * * ladies and gentlemen, i am delighted to have been invited by clare college, cambridge, to give this lecture in economics and public policy. one of the greatest challenges for economics and public policy at this time is to restore financial and economic stability, and to improve the future functioning of financial systems. a pre - condition for meeting this challenge is a deep understanding of the nature of systemic risk. and that is the topic i have chosen for this lecture. systemic risk in europe ’ s financial system is a very important issue for the european central bank. and as an institution of the 27, through its general council in particular, the ecb is one of the continent ’ s guardians of economic stability. we are charged in particular with maintaining price stability in the euro area over the medium term. but the ecb is also an active participant in the new agenda of financial stability. as you will be aware, restoring financial stability and containing systemic risk in the future are at the heart of the supervisory and regulatory reforms currently being discussed here in europe and elsewhere. i am particularly pleased to give this lecture at cambridge university, which has been an intellectual “ powerhouse ” for centuries. it is said that the university has more nobel prize winners associated with it than any other institution. perhaps the most well known nobel laureate from clare college is james watson, who, together with francis crick, derived the structure of dna. dna incorporates the building blocks of life. as the recent instability illustrates, we economists still need to achieve as clear an understanding of the building blocks of financial systems – not simply the institutions small and large that populate them, but also the fundamentals of the rules and incentives that drive their behaviour ; and, particularly, how they combine and interact with each other in the presence of amplification mechanisms stemming from leverage and other forces. let me mention two more recent nobel laureates in economics whose work relates to my topic today. in 1996, james mirrlees of trinity college won the nobel prize for his contributions to the economic theory of incentives under incomplete information. in 2001 joseph stiglitz, who spent time in cambridge in the 1960s, won the prize for his analysis of the functioning of markets when information is asymmetrically distributed. 1 i