Speech by Governor Frederic S. Mishkin, Financial Instability and Monetary Policy

Below are the concluding remarks of the speech...

"As I have argued here, under the mandate it has been given by the Congress, the Federal Reserve has a responsibility to take monetary policy actions to minimize the damage that financial instability can do to the economy. I hope I was clear in communicating to you that policies to achieve this goal are designed to help Main Street and not to bail out Wall Street. Pursuing such policies does help financial markets recover from episodes of financial instability, and so it can help lift asset prices. But this does not mean that market participants who have been overly optimistic about their assessment of risk don't pay a high price for their mistakes. They have, and that is exactly what should happen in a well-functioning economy--which, after all, is what the Federal Reserve is seeking to promote."

In the following paragraph, Mr. Mishkin describes the characteristics of high-risk investments like what happened with the mortgage subprimes...

"Adverse selection arises when investments that are most likely to produce an undesirable (adverse) outcome are the most likely to be financed (selected). For example, investors who intend to take on large amounts of risk are the most likely to be willing to seek out loans because they know that they are unlikely to pay them back. 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."

It is worth mentioning that Mishkin emphasizes that the FED works to restore financial stability and is not promoting a bail out of Wall Street. It also differentiates this instability from economic risk but that the first could filter through to the latter.

This is an interesting speech and I recommend reading it.