a sharp increase in risk premia that precipitate a fall in asset prices and that in turn leads to what economists and engineers call " positive feedback " dynamics. as firms and investors move to hedge against future losses and to raise money to meet margin calls, the brake becomes the accelerator : markets come under additional pressure, pushing asset prices lower. volatility increases. liquidity in markets for more risky assets falls. in systems where credit is more market - based and more credit risk is in leveraged financial institutions outside the banking system, a sharp rise in asset - price volatility and the concomitant reduction in market liquidity, can potentially have greater negative effects on credit markets. if losses in these institutions force them to withdraw from credit markets, credit availability will decline, unless or until other institutions in a stronger financial position are willing to step in. the greater connection between asset - price volatility, market liquidity and the credit mechanism is the necessary consequence of a system in which credit risk is dispersed outside the banking system, including among leveraged funds. this does not make the system less stable, though, only different. for if risk is spread more broadly, shocks should be absorbed with less trauma. moreover, the system as a whole may be less vulnerable to distortions introduced by the moral hazard associated with the access that banks have to the safety net. a second issue we need to consider stems from the complexity of the new credit instruments, the challenges they present in terms of valuation and risk measurement and their short history of experience in times of stress. even the most sophisticated participants in the markets for these instruments find the risk management challenges associated with these instruments daunting. this raises the prospect of unanticipated losses. default rates are harder to predict where there has been a substantial change in the financial attributes of borrowers. the prices of instruments may not respond as expected to a given change in losses or in the value of the assets underlying these instruments. hedging strategies may prove to be less effective than expected. similarly rated instruments can behave very differently in stress events. the response of prices and volatility to the downgrades in the automobile sector in the spring of 2005 and the recent experience in subprime mortgages and related asset - backed securities and credit derivatives illustrate different types of surprises faced by the participants in these markets. they are a reminder of the dimensions of uncertainty that exist about the shape of the distribution of potential returns. this

william c dudley : road to recovery – hudson valley remarks by mr william c dudley, president and chief executive officer of the federal reserve bank of new york, at the state university of new york at new paltz, new paltz, new york, 19 may 2011. * * * good morning. i am pleased to be in new paltz to speak to you and meet with the business, community and academic leaders of the hudson valley. i particularly want to thank the ulster county chamber of commerce and community capital resources of the hudson valley, the dutchess county regional chamber of commerce, the dutchess county economic development corporation and the orange county chamber of commerce who assisted us with our recent survey of small business finances. more than 100 businesses responded from the mid - hudson region. the survey results will be published early this summer and, of course, we will share the results with you and post them on our website. each visit to this area gives me a chance to deepen the bank ’ s relationship with the people whom i represent as head of the federal reserve bank of new york. last summer i travelled through central and western new york and met with community leaders, business people, academics, bankers and government officials. on this visit i will also meet with a wide range of people to talk about what we do and to hear first - hand the economic and financial issues important to you in the hudson valley so that i can best represent all my constituents in my work at the fed. i also look forward to walking across that magnificent old railroad bridge, the walkway over the hudson, for the spectacular view that i ’ m told awaits me. i thank the center for research, regional education and outreach for inviting me to speak at suny new paltz today. this morning i will talk about economic conditions in the nation and the region, paying particular attention to how the recession has affected the labor market here. as always, what i have to say reflects my own views and not necessarily those of the federal reserve system or the federal open market committee ( that is, the committee that sets interest rates – also known by its initials as the fomc ). introduction to the new york fed by way of introduction, let me start with a synopsis of what the new york fed is, what we do and what makes my job so interesting. the new york fed is part of the federal reserve system, america ’ s central bank, which was created by congress in 1913. with this act, congress delegate