As witnessed during the 2007–09 financial crisis, overheating in credit markets can trigger major financial system distortions and massive output losses. The author makes three contributions toward a fuller understanding of these episodes of overheating. First, he develops an explanation of overheating that highlights the role of institutional structures and the incentives faced by decision makers in the financial industry. His explanation complements the more conventional focus on changes in the preferences and beliefs of end investors. Next, the author considers recent developments in various sectors of the credit market and looks for signs of overheating. Finally, he discusses the respective roles of supervision and monetary policy in addressing credit market overheating.

The idea that institutional structures and incentives affect credit markets derives from the observation that credit decisions are frequently delegated to employees at financial institutions. The actions of these agents are influenced by incentives shaped by regulations, accounting standards, governance systems, and compensation structures. The agents try to maximize their own compensation under the prevailing rules. On occasion, they discover vulnerabilities within the rules, which they exploit to their advantage. Although the combination of private governance and public policy is generally effective in containing these agency problems, risk taking can become excessive.

The author lists three factors that are likely to contribute to overheating. The first is financial innovation, particularly as it relates to the ability to write yield-enhancing puts that are not captured by existing rules. The second factor is regulatory change, which tends to generate further innovation aimed at minimizing the private costs of new rules. The third factor is a sustained change in economic conditions, such as the currently observable prolonged period of low interest rates, which may force agents to accept greater risks in an attempt to enhance yield.

The institutional view has direct implications for the measurement of risk. Importantly, nonprice terms can contain information about changes in risk appetite. In his review of recent developments in selected areas of the credit market, the author considers some of these nonprice indicators. Several features in the corporate credit market—such as the high-yield share, covenant-lite loan issuance, and an increase in leverage of leveraged buyouts—lead him to conclude that the sector currently exhibits above-average risk. In contrast, the share of short-term financing for corporate debt securities appears to be moderate and remains well below its pre-crisis level. Thus, deleveraging attempts should not have major systemic implications.

Agency mortgage REITs have witnessed significant growth over the past few years. They deserve to be monitored carefully because the funding of mortgage-backed securities in the short-term repo market implies a leveraged carry trade, which is sensitive to interest rate developments.

The maturity of securities in the available-for-sale portfolio of commercial banks appears to be near the upper end of its historical range. According to the author, the added interest rate exposure is a meaningful source of risk and also signals a pressure to boost income that may encourage risk taking in other less readily observable ways.

Finally, the author takes issue with the view that monetary policy should be used only to achieve price stability and maximum employment, whereas supervisory and regulatory tools exist to safeguard financial stability. He believes monetary policy can also make a contribution toward financial stability. Monetary policy can be used to promptly address financial stability concerns: It reaches all sectors of the financial market, and it can influence term premiums and the shape of the yield curve. Thus, the author suggests a greater overlap in the goals of monetary policy and regulation.

The empirical evidence provided by the author draws mainly on work of the Federal Reserve staff in the context of the ongoing quantitative surveillance efforts as well as on recent academic studies about nonprice indicators of risk.

This research is post-crisis in both its style and its approach. Although the research is partly theoretical in nature, it does not rely on mathematics but, rather, builds a convincing and well-structured narrative supported by empirical observation. With his focus on incentive structures, the author contributes to a better understanding of financial market weaknesses and identifies potential warning signs.