![]() If the damage caused is significant enough, the rules themselves adapt, driven either by internal governance or by political and regulatory forces. Sometimes they discover vulnerabilities in these rules, which they then exploit in a way that is not optimal from the perspective of their own organizations or society. At any point, the agents try to maximize their own compensation, given the rules of the game. And these incentives are in turn shaped by the rules of the game, which include regulations, accounting standards, and a range of performance-measurement, governance, and compensation structures.Īt an abstract level, one can think of the agents making credit decisions and the rulemakers who shape their incentives as involved in an ongoing evolutionary process, in which each adapts over time in response to changing conditions. The premise here is that since credit decisions are almost always delegated to agents inside banks, mutual funds, insurance companies, pension funds, hedge funds, and so forth, any effort to analyze the pricing of credit has to take into account not only household preferences and beliefs, but also the incentives facing the agents actually making the decisions. 6 This finding is consistent with the importance of primitive investor beliefs.īy contrast, I am skeptical that one can say much about time variation in the pricing of credit-as opposed to equities-without focusing on the roles of institutions and incentives. 5 More generally, research using survey evidence has shown that when individual investors are most optimistic about future stock market returns, the market tends to be overvalued, in the sense that statistical forecasts of equity returns are abnormally low. It seems clear that the sentiment of retail investors played a prominent role in inflating this bubble. The primitives view is helpful for understanding some aspects of the behavior of the aggregate stock market, with the 1990s Internet bubble being one illustration. 3 Or maybe credit is cheap when households extrapolate current good times into the future and neglect low-probability risks. Perhaps credit is cheap when household risk tolerance is high-say, because of a recent run-up in wealth. While the first view is a natural starting point, I will argue that it must be augmented with the second view if one wants to fully understand the dynamics of overheating episodes in credit markets.Īccording to the primitives view, changes in the pricing of credit over time reflect fluctuations in the preferences and beliefs of end investors such as households, where these beliefs may or may not be entirely rational. I will start by sketching two views that might be invoked to explain variation in the pricing of credit risk over time: a "primitive preferences and beliefs" view and an "institutions, agency, and incentives" view. The question I'd like to address today is this: What factors lead to overheating episodes in credit markets? 1 In other words, why do we periodically observe credit booms, times during which lending standards appear to become lax and which tend to be followed by low returns on credit instruments relative to other asset classes? 2 We have seen how such episodes can sometimes have adverse effects on the financial system and the broader economy, and the hope would be that a better understanding of the causes can be helpful both in identifying emerging problems on a timely basis and in thinking about appropriate policy responses.
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