Remarks
Robert B. Litterman
Goldman, Sachs & Co.

Last year, when the Bank of Japan, the Bank for International Settlements, theBank of England, the Board of Governors of the Federal Reserve System and theFederal Reserve Bank of New York agreed to host this conference as part of theircontinuing efforts to conduct research into the robustness of financial systems andmarket mechanisms under stress, they could not have anticipated the events of thepast several months.
We have, in an incredibly short period of time, gone from a financial market
environment characterized by “exuberance” to one in which asset prices inemerging markets have collapsed and the avalanche of losses in relative value
trades created by the excessive leverage and subsequent collapse of an unregulated quantitative hedge fund, Long Term Capital Markets, nearly brought disasterto financial markets. Although the markets currently seem relatively calm, not solong ago we seemed to be heading toward massive illiquidity, widening credit
spreads, declining stock prices, and global financial market gridlock.
I have to admit, I am thankful, but also quite frankly shocked, that a surprise
25 basis point cut in the US federal funds rate apparently signaled the determination of the Federal Reserve to provide liquidity and seems to have had such a
positive and profound effect on investor psychology.
No doubt others understand the workings of financial markets better than I,
but my reaction as I think through the issues raised in this conference in thecontext of recent events is that we financial economists really understand very
little about how the financial system will react in conditions of stress.
The financial system is, after all, in reality an incredibly complex, non-linear,
non-stationary system, populated by a community of emotional informationprocessing animals whose nervous systems evolved over millions of years, prior
to the invention of money. Today this system is globally connected by networks
and computers that instantaneously communicate and process information. I’m
not sure we can be confident in its stability or its rationality.
In fact, our limited understanding of the reaction of the financial system tostress has been a common theme in several of the papers presented at this conference. I applaud these authors for being so honest.
To quote a few examples (though I admit that these quotes are perhaps taken outof context) De Bandt and Hartmann in their survey article write, “While ‘systemic

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risk’ is now widely accepted as the fundamental underlying concept for the studyof financial instability and possible policy responses, most work so far tackles one
or several aspects of that risk, and there is no clear understanding of the overall
concept of systemic risk and the linkages between its different facets.”
Yoshifuji and Demizu apply some tools from the recently developing scienceof complexity theory and conclude “There are still numerous outstanding issues
regarding each analysis and we do not draw any definitive conclusions.”
Despite this uncertainty, many of the presenters at this conference havenonetheless attempted to build models of financial markets under stress. Models
can be described as either structural, which attempt to model cause and effect, or
reduced form, which simply try to capture statistical relationships in historical
data. We have seen many examples of the latter, which obviously have less ambitious goals, but also which hopefully point in the direction of helping to clarify
with which empirical facts the structural models should attempt to be consistent.
Unfortunately, even the empirical regularities which are found are often only very
approximate, uncertain, unstable, and often linear descriptions of economic
phenomenon.
The structural models, which are the type of model required to investigate theimpacts of alternative policies, are generally even more approximate, uncertain,
and difficult to validate. And compounding the usual difficulties in economic
science, the particular problem that we have in modeling markets in times ofstress is that we have only a handful of examples of relevant data, and it is very
difficult to test hypotheses against the evidence of a few historical events and,needless to say, expensive to generate new data.
Nonetheless, we have had presented here a number of very interesting anduseful structural models. A common theme of these models is to justify, or at least
raise issues about, the role of the central bank as a lender of last resort. For example, two models of payments systems, both the mathematically sophisticated, butnonetheless very practical model of Fujiki, Green and Yamazaki, and the location
model of Freixas, Parigi, and Rochet, attempt to provide such a role for the central bank.
Models and their limitations are a common theme in conversations among risk
managers recently. Risk managers in financial institutions today rely extensively
on statistical models to quantify the degree of uncertainty in the distribution ofoutcomes of their investments. With a fair amount of effort and attention to detailthese “Value-at-Risk” models can give a quite good idea of what the distributionof outcomes will look like most of the time.
Unfortunately, as many of us have recently been made very aware, financial firmmanagement cares very little about what happens most of the time, but cares a lot
about what might happen in periods of financial market stress.
Although we rarely see the financial markets in stress, we have seen suchconditions often enough to know that the system has a tendency, in periods ofstress, to feed back on itself and create highly non-linear patterns of behavior.

Two examples of such reaction in recent years are noteworthy. In 1987 thethen relatively new, but popular investment strategy, “portfolio insurance,” created an automatic increase in sellers attempting to get out of the market if it were to
start to decline in value. In October, 1987, market participants, sensing that a
price decline fed by portfolio insurance selling was underway, headed for coverand liquidity vanished as large sellers expecting relatively liquid and continuous
markets were unable to get out. By the time the market reached a new equilibrium
prices had declined, relative to previous volatility, by 25 standard deviations.
More recently, overly leveraged relative value traders at hedge funds and other financial institutions who were forced into sales ran into a similar decline inliquidity coupled with a radical increase in price volatility. For relative value andspread traders the combination of higher volatility, high cross-correlation of
returns across the many markets in which they were involved, and positive serial
correlation-as these trades moved against the hedge fund community for several
weeks in a row-created a similar 25 standard deviation event relative to the risk
measured in prior periods.
And although most of us in the risk management business were quite preparedto admit that financial markets are not normally distributed, most of us were notprepared for an event of this magnitude. Significantly, one of our biggest mistakes
was to treat market prices as if they were exogenous processes. Just as in 1987,
market participants following a new type of trading strategy themselves createdthe overhang that led to the collapse of liquidity and increased volatility that
subsequently engulfed them and other market participants in losses beyond all
previous experience. In both cases the external shock which touched off the event
was not particularly large.
These two events suggest that it will be very difficult to extrapolate typicalmarket behavior to periods of stress. Several of the papers at this conference havetouched on this theme, particularly the Rational Expectations Model of Financial
Contagion by Kodres and Pritsker.
One of the more disturbing features of recent events is the light they have shed on
the ineffectiveness of the current financial firm regulatory framework. Highly
regulated banks extended loans without margin to an entity whose positions andleverage were unknown. Global securities firms created huge off-balance-sheet
exposures through unregulated derivatives business entities. At least one hedge
fund became perceived as too big to fail when, very late in the game, regulators in
the Federal Reserve System saw its positions.
Although regulatory policy was not a focus of the conference, as mentioned
before, models providing a role of central banks as lender of last resort werediscussed in several papers. In addition, a number of papers question the wisdomor magnitude of such a role. Goodfriend and Lacker draw the illuminating comparison between central bank lending and private lending and make the important
point that agents’ behavior will change, and potentially create large hidden costs,
particularly those associated with excessive risk taking, when agents are con-

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fronted with a more lenient central bank lending policy regime. Central banks can
say whatever they please about not bailing out institutions that get into trouble,
but as every parent understands, “actions speak louder than words,” and theauthors argue the only practical way for a central bank to credibly commit to limit
its lending is for it to build up a reputation over time for not lending.
Similarly, Shimizu and Ui question “whether or not the current execution
framework of lender of last resort falls short in providing outcomes which aresocially optimal with regard to the purpose of avoiding systemic risk.” And myformer colleagues at the Minneapolis Federal Reserve, Rolnick, Smith, and Weber,measure the benefits provided by a private bank, acting as lender-of-last-resort ina context in which no central bank existed.
What do I conclude as I think about these issues? First of all, I think I must admitthat I know very little about systemic risk and contagion, thus I should be cautious about concluding anything. Perhaps we all should be very careful to highlight what we do not know about this topic, lest policy makers put too much faithin our conclusions.
Second, clearly we have seen that financial markets under stress behave quite
differently than during normal times, thus we must be very careful not to extrapolate normal behavior to that during periods of stress. Those of us who use
statistical risk models, in particular, should augment them with scenario analysis,
stress tests, and other more qualitative judgements, not to mention a pool ofcapital with a significant buffer for model risk.
Third, let us be very careful about the unintended consequences of governmental policies. Citizens certainly expect their central banks to try to protect theireconomies from the real economic losses associated with financial market disruptions. Thus, in times of financial stress we should expect political pressures on
governments and their central banks to take actions to protect against systemic
failure.
Nonetheless, I would caution-as do several of the presenters at this conference-that governments must be conscious of the unintended side effects of theiractions. In particular, in this context we should be careful that our concern aboutsystemic risk, which is understandable, does not create an environment in whichcentral banks and other regulators will have a political imperative to provide
liquidity in times of stress, and ultimately to become lenders of last resort. No
matter what is the stated policy, market participants will observe and understandpolitical realities, and if that reality is a free put option for large financial firms
then those firms will have incentives to take on more risk than they otherwise
would. In this case the unintended side effect of a concern about systemic risk
would then itself be the creation of more systemic risk.
After all these cautions, I feel compelled to try to suggest some positive actions that governmental entities can take to reduce systemic risk. I think theanswer is simple and obvious: “be prepared.” The most destructive element of afinancial disaster is the panic and emotional flight to safety and liquidity that itcreates. Governments should prepare themselves and strongly encourage theirregulated financial institutions to be prepared ahead of time for this type of environment. Financial panics will happen, but if there are enough institutions prepared to take advantage of the opportunities they present, the outcomes won’t be
so bad.
Preparation means adequate capital, adequate liquidity, perhaps purchase ofvarious types of financial insurance, more and more of which becomes available
each year. But most importantly being prepared simply means thinking through,ahead of time, the implications of various financial market scenarios and the
optimal actions required.
Financial institutions, as well as governmental bodies, should have written
policies and plans describing how they will react to the next financial crisis. The
same kind of extensive preparations that are currently being made for the year
2000 should also be in place for the next stock market crash, for the next major
financial system bankruptcy, and so on.
Business schools and perhaps central banks should sponsor courses in thehistory of financial panics, and I applaud the papers presented by Schoenmaker,
and Rolnick, Weber and Smith, for their contributions in this area.
Central banks should also have disaster training courses for their staff. Just as
the military has boot camp, war games, and so on to prepare for any kind ofmilitary conflict, central banks should think through financial disaster scenariosand develop similar exercises and game plans in order to be better prepared for all
types of market events.
And as part of their planning central banks should have clearly articulated andpublicly stated policies for what they will do, and what they will not do, in such
scenarios. I would strongly encourage central banks to articulate a policy that no
institution is too big to fail and to think through the implications of such a policy.
I encourage private sector initiatives to prepare for large financial institution
failures—and in fact I would encourage central banks to suggest to other financial
institutions that they view financial shocks as opportunities—and to be preparedto take advantage of them.
While the types of policies I advocate will marginally reduce profitability forfirms in normal times, because they will encourage paying for various types of
insurance and will encourage them to take less risk, such actions are very likely tobe profitable in the long run since many of the best opportunities are available
only during periods of general distress. And perhaps more important for enhancing shareholder value we all understand that a firm which generates higher returns
during such periods of financial stress is worth much more than would be a firmthat produces the same total returns, but only during good times.
Thus, to summarize, I think governments should focus less of their time, energy and resources in trying to prevent financial disruption. And I definitely think
governments should not provide free disaster insurance to bankrupt firms andcountries. Rather governments should adequately prepare themselves, and en-

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courage all private participants in financial markets to prepare themselves for the
next financial market shock.
We should all assume that financial shocks will occur. There is uncertainty inthe real world, and in equilibrium there will be shocks to the financial systemwith real consequences.
Ironically, however, if we are all prepared for such shocks, then that preparedness in itself will make the next financial shock less painful, and panic and contagion less likely to occur.
Finally, I would like to say that I view conferences such as this as an importantpart of a policy of attempting to better understand and prepare for future financial
market disruption, and thus I want to sincerely thank the conference sponsors,participants, presenters and organizers for all of their efforts and hard work.