moral hazard arises because a borrower has incentives to invest in high - risk projects, in which the borrower does well if the project succeeds but the lender bears most of the loss if the project fails. historically, banking institutions and other financial intermediaries have played a major role in reducing the asymmetry of information because they are well placed to collect information from borrowers and to engage in long - term relationships with clients. in more recent times, note that my remarks here reflect my own views and not necessarily those of others on the board of governors or the federal open market committee. i thank roberto perli for his excellent comments and assistance on this speech. a more detailed discussion of my views on what causes financial instability and of the effect of such instability on economic activity is in mishkin ( 1997 ). improved transparency and financial innovation – in the form of new financial products as well as new types of institutions that have become active in markets – have also contributed to the efficient flow of information across the system. the continuity of this flow helps keep adverse selection and moral hazard in check and is crucial to the process of price discovery – that is, the ability of markets to collect information and properly evaluate the worth of financial assets. during periods of financial distress, information flows may be disrupted, and price discovery may be impaired. the high risk spreads and reluctance to purchase assets that are characteristic of such episodes are natural responses to the increased uncertainty resulting from the disruption of information two types of risks are particularly important for understanding financial instability. the first is what i will refer to as valuation risk : the market, realizing the complexity of a security or the opaqueness of its underlying creditworthiness, finds it has trouble assessing the value of the security. for example, this sort of risk has been central to the repricing of many structured - credit products during the turmoil of the past few months, when investors have struggled to understand how potential losses in subprime mortgages might filter through the layers of complexity that such products entail. the second type of risk that i consider central to the understanding of financial stability is what i call macroeconomic risk – that is, an increase in the probability that a financial disruption will cause significant deterioration in the real economy. because economic downturns typically result in even greater uncertainty about asset values, such episodes may involve an adverse feedback loop whereby financial disruptions cause investment and consumer spending to decline, which, in turn, causes economic activity to contract. such contraction

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