encourage “ herding ” behaviour within the financial system that raises the costs of taking a contrarian view. and there are also well - documented concerns that regulatory design pays insufficient attention to the risk of procyclicality 6. 38 it also appears to be the case that many firms failed to take sufficient account of the likely behaviour of other firms, and thus of system properties, when designing stress tests and contingency plans. they were far too confident in their ability to exit or hedge positions in high risk instruments, where trades were highly crowded, and were consequently underprepared for the evaporation of market liquidity. 39 moreover, there are some financial instruments ( such as mortgage - backed securities where the mortgages have prepayment options ), where the dynamic hedging behaviour of holders can amplify the price movement, as dynamic hedging can lead to additional short hedging positions being required after a price fall. with individual institutions being small relative to the market, each individual institution may think that their new short position will have little or no impact on market prices. but collectively, the aggregate demand for new short positions is likely to drag prices further down and amplify the original shock, generating additional losses for those who were slower to update their dynamic hedging 7. section 5 : some lessons and policy responses 40 we are now around a year into a severe credit crisis centred on many of the complex structured instruments described earlier. an immediate behavioural response of risk managers in major financial institutions has been to pull out of these markets entirely. this has dramatically reduced primary and secondary market liquidity and increased price volatility, further reducing incentives to invest in these instruments. the short term outlook for many of these innovative instruments is poor. and as described in section 4, the past year has revealed that market imperfections and frictions are more potent than was previously thought. it is clear that there are important limitations on the capacity of the financial system to deliver all of the benefits of financial innovation spelled out in section 3. but equally it would be wrong to jump to the opposite extreme, given there are clearly major welfare gains from improved choice of financial products and better matching of risks. 41 so what are some of the lessons for financial innovation? what will the landscape look like in 5 - 10 years ’ time, once the dust has settled and institutional changes can be implemented to address the frictions identified? what if anything can policy do to facilitate or expedite

, banks have been forced to write down the value of contracts that they had bought from monoline insurers to guarantee the payments promised by their holdings of highly - rated cdos linked to us sub prime mortgages. with the likelihood of such guarantees being called upon appearing very small, the monolines wrote a large volume of such guarantees. but more recently, this prospect has become a distinct possibility, and one that threatens the viability of some of the monoline insurers, and thus their perceived ability to pay. incentives 24 these information problems are difficult enough when risk is treated as exogenous. and in a world of full information, “ nature ” can be the only source of uncertainty. but in practice when there is a lack of information and uncertainty about actions, the incentives facing individual actors become very important and can lead to endogenous risk creation within the financial system. 25 these incentive problems have been clearly apparent in risk transfer markets. as has been widely described elsewhere, if loan originators do not have sufficient capital at stake, they will not screen potential borrowers adequately. 5 in the us sub - prime mortgage market, rewarding loan originators by volume of issuance was a recipe for lax credit assessment standards. but even when originators seem to have an economic stake in performance, for example by holding some of the “ first loss ” or equity tranche of a securitisation, this is not sufficient to guarantee incentive compatibility, as it is possible to hedge the exposure to the equity tranche through a separate market transaction. 26 there is, though, also a more subtle problem. as mentioned above, holding a diversified pool provides protection against idiosyncratic risk. but the absence of a concentrated exposure can also limit the incentive to monitor individual loans, and thus the pooling of risk may lead to a reduction in the overall level of risk screening ex ante and monitoring ex post. it was the combination of these misaligned incentives that proved such a problem in the us sub - prime mortgage market. individual end - investors had little incentive to monitor the performance of loan originators, perhaps presuming that originators had sufficient stake in the securitisation to provide market discipline. issuers, though, transferred much of the risk and did so comprehensively, as they needed to demonstrate that they had transferred risk irrevocably before they could get capital relief. but in the absence of adequate monitoring, originators could chase volume at the expense