Remarks
Kenneth J. Singleton
Stanford University

The last Central Bank Conference two years ago focused primarily on themechanics of risk management. This Conference has shifted attention to theaggregate “systemic” implications of disruption of financial markets and the roles,
if any, of central banks and regulatory agencies in mitigating the cost of suchdisruption.
Of course, before assessing the roles of regulatory agencies, it is helpful tohave a common understanding, even if not a precise definition, of what systemicrisk is. Several authors have ventured forward with definitions of systemic riskover the last two days and my reaction, and I suspect the reaction of many of you,was that none of these definitions was completely successful in capturing what, at
an intuitive level, we think of as systemic risk. I am not going to attempt a more
precise definition. However, perhaps what central bankers have in mind, when wehear so much emphasis placed on systemic risk, is concern about disruption in
financial markets that potentially gives rise to the need for intervention. Such
periods may coincide with periods of high volatility, but certainly disruption thatwarrants interventions need not be equivalent to the presence of high volatility.
Pursuing this viewpoint leads naturally to the following two questions: (1)What types of turbulence give rise to a potential need for intervention by central
bankers (or other regulatory or multi-national agencies)?; and (2) If intervention
is called for, then what form should it take? It may be that periods of turbulence,
if I can use that word, during which intervention would be contemplated, areassociated with correlated movements in markets and/or correlated defaults. But,of course, this does not imply that the presence of correlated defaults and correlated movements among markets should necessarily lead to an intervention by
any regulatory agency. To put this point differently, I have placed on the overhead
projector a slide that displays, from 1983 to the present, the movement in speculative grade (all bonds rated below BAA) default rates in the U.S. corporate bondmarket against a four-quarter moving average of GDP growth. One would certainly come away with the impression that that there are correlated defaults acrossissuers and that default rates are highly correlated with the business cycle (thecorrelation of the default rate with GDP is about -.8). Yet I do not think we would
argue that these cyclical correlations, by themselves, justify central bank interventions in corporate bond markets. Similarly, correlated movements in asset
prices across markets and countries, by themselves, do not call for interventions.

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That is, I do not think that correlation per se across market prices or default rates
is what people have in mind when discussing systemic risk.
What do people have in mind? My thinking about this question has been influenced a great deal by the informative discussions over the last two days. In
particular, I have a much better sense of the questions that need to be asked before
reaching a conclusion about the merits of policy interventions in turbulent markets. What people seem to have in mind is the possibility that the normal functions of markets and market systems break down in such a way, and on such ascale, that intervention is called for to prevent or mitigate system failure. And theassessment of what is “called for” should be based on an assessment of the tradeoffs—the costs and benefits—of intervention, perhaps along the lines of the tradeoffs Ed Green laid out for us in earlier discussions.
The papers presented at this conference have addressed a number of important
facets of systemic risk and, in reviewing some of the key observations, I find it
convenient to distinguish between the three areas of payment systems, banking
systems, and securities markets. The papers on systemic risk in payment andsettlement systems have been truly fascinating. The papers by Fujiki, Green andYamazaki, Freixas, Parigi, and Rochet, and the simulation papers, for instance by
Muranaga and Shimizu, have made significant contributions to our understandingof the potential sources of disruptions in settlement systems and the potential
roles of intervention in the workings of a payment system. The models are stylized and probably do not lead, at this early stage of development, to concrete
policy prescriptions. Nevertheless, I found them to provide useful guidance as tothe types of circumstances in which policy intervention might be warranted, andalso circumstances where it may appear that such an intervention is warranted,
but perhaps indeed it is not. That is, this research will hopefully help us identify(and focus on) key variables that will give us “signals” as to whether or not someform of intervention is warranted.
In the banking area, an important contribution of many of the papers presented
at this conference is the careful analysis of several case studies of previous banking panics. As several of today’s panelists have stressed, such historical studies
help us understand how in different market environments and at different times inhistory, policy interventions have worked under different financial arrangements
to mitigate financial crises. Though, at the same time, from a more prospective
viewpoint, today’s discussion left me wondering how the authors would answer
the following question: In our current market environment, with existing financial
safeguards in place, should we have serious concerns about bank-runs or othertypes of systemic crises in the banking sector? Several representatives of theFederal Reserve System expressed the concern that moral hazard problems withregard to central bank interventions in markets have become more severe, becauseof recent central bank actions. I would like to hear more from other participants
here who have been thinking about and researching these issues.

Finally, tuning to the securities markets, this is the area where our ignorance
about the consequences of systemic risk seems greatest. Our understanding of thelinks between market turbulence, the mechanisms which create turbulence, andthe potential role for regulatory agencies in mitigating some of its economic
consequences remains quite limited. I applaud the authors of the papers thatexamine spillover effects across market volatilities and returns, globally anddomestically. Equally interesting were the papers that examined the behavior of
securities prices in particular markets during periods of stress. Yet, the links
between these studies and the theme of this conference—systemic risk and therole of central banks or other agencies in mitigating such risk—seems quite weak.
Spillover effects—equivalently, correlation in most of these studies—acrossmarkets are not equivalent to the presence of systemic risk, in my view.
Since the potential for systemic risk in securities markets is the area closest to
my own research, I would like to briefly expand on this last point. Let me take anasset pricing perspective and abstract from problems with payment/settlement
systems and the informational problems related to banks and bank runs. Consider
the problem of pricing a corporate bond. Though a corporate bond is a defaultable
instrument it is, in an important sense, an inherently linear instrument. That is,under reasonable assumptions, we can value the cash flows on a corporate bondby treating the future cash flows as if they are riskless and then discounting theseflows by a default-adjusted discount rate. The fact that the bond may default isreflected entirely in the adjusted discount rate, and the value of the sum of cash
flows is the sum of their individual values. Moreover, standard “arbitrage-free”
pricing methods are applicable and, indeed, this is how corporate bonds are often
valued by financial institutions during “normal” times.
Now suppose that the probability of default, or recovery in the event of default, is itself dependent on market prices. This circumstance may be what Bob
Litterman had in mind when he referred to endogenous pricing. In this case, itturns out that the pricing problem for a corporate bond is fundamentally different
than the previously described case. Specifically, pricing is no longer linear and, inparticular, the price of a corporate bond is no longer the discounted sum of theprices of its promised cash flows. While we can, in principle, formally accommodate this type of non-linearity in our pricing models, the models typically used bytrading desks and risk management teams are of the linear type.
Thus, if we encounter circumstances where there is endogeneity of price determination in the sense of dependence of the probabilities of default or recovery
on market prices, or market participants act as if this is so, then a fundamental
nonlinearity may immediately enter market price behavior and our basic pricing
models no longer hold. Systemic risk in securities markets might be thought of as
the simultaneous occurrence of this type of non-linearity in pricing across several
markets or instruments. Taking this perspective, it seems difficult, if not impossible, to examine empirically the phenomenon of market stress-induced endogenous
pricing using a standard, linear valuation framework.
It is interesting to note that liquidity crises, or at least one view of such crises,

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is isomorphic to this default problem. What I have in mind is viewing a substantial change in the liquidity of a security as an unpredictable change in market
value much like default. In the case of a liquidity crisis, one does not lose all of
the market value prior to default so, by analogy to the default case, there is afractional recovery (or equivalently loss) of market value. In a systemic liquidity
crisis, the fractional losses depress the prices of several instruments simultaneously. And, just as in the default example, if the loss fraction or the “intensity” ofthe crisis depends endogenously on market prices, then nonlinear pricing will
apply.
Returning to my default example, these remarks about nonlinear pricing andjoint endogeneity of prices in several markets should be distinguished from thetype of correlated default I discussed in my own presentation. In my research on
simulating correlated defaults, there are simultaneous jumps in the probabilities ofdefault, but the hazard rates of default (the default intensities) were taken to be
exogenous processes. Therefore, pricing was linear. One way to highlight thedistinctions between linear and nonlinear pricing, is to think about the 25 standard
deviation analogy that Bob Litterman gave when discussing recent events inglobal bond markets. Recent events were clearly outside the scope of the shocks
and reactions embodied in most risk management and pricing systems. Were thefailures of existing systems because we had mis-specified the distributions of the“shocks” in our models? Are shock distributions not only non-normal, but withmuch fatter tails than we had accommodated? Or was it the case that there was
too much linearity in our pricing systems and that recent events lead to nonlinear
and large responses of market prices to large, though not extreme, economic
shocks? That is, was there endogenous price reaction, perhaps along the lines ofthe preceding remarks on price dependence of default and liquidity premiums? I
suspect that it is the latter concern, and not the former concern about misspecified shock distributions, that most people are worried about when we experience large deviations from “normal times.”
The level of ignorance that we have about the nature of liquidity crises and nonlinearity in pricing is illustrated by two episodes that several of the panelists havealready discussed. One is the market’s reaction to Greenspan’s recent, unexpected
cut in interest rates. I, like Bob Litterman, am amazed at the apparent consequences of Greenspan’s action for stabilizing markets. While the markets’ reactions could be interpreted within the nonlinear pricing settings discussed a few
minutes ago, it remains unclear to me what mechanism would have brought about
the endogeneity and consequent non-linearity to begin with.
The second episode is the intervention by the Federal Reserve System in the
LTCM bail out. On this issue my views differ somewhat from those of at least
some of the panelists. To me, the key issue was not whether LTCM was too big toliquidate. I believe that liquidation of LTCM would likely have caused major,
further disruptions in financial markets. Rather, I think the key question is whether private agents, acting without the intervention of regulatory agencies, would

have reached a resolution of the problem on their own without forcing totalliquidation of the portfolio. In other words, pertinent questions would seem to be:(1) Were private agents willing to step in and buy out the portfolio of LTCM?, and(2) If they had stepped in would they have aggravated market conditions by
forcing an immediate liquidation of the positions? With regard to the second
question, the answer is clearly no. A consortium of financial firms essentiallytook over the positions of LTCM and it has been proceeding with an orderly
liquidation of portions of the portfolio. This is as would be expected, since firms
injecting their own capital into LTCM or any other financial investment would
have no incentive to liquidate immediately if this would lead to a substantial lossof value. Regarding the first question, there has been debate in the press about
whether there were private bids for the balance sheet of LTCM that would havebeen viable in the absence of some intervention by the New York Federal Reserve.
And it is difficult to know how the bidding would have proceeded had the Federal
Reserve not become involved in negotiations (Would other bidders have surfaced? Would LTCM taken the Buffet bid given no apparent alternative? etc.).
Given the themes of this conference and the expressed concerns about moral
hazard problems created by the actions of the Federal Reserve, one could cogently argue that their intervention, even though not involving an immediate
financial outlay, exacerbated the moral hazard problem. Furthermore, one mightreasonably question whether the intervention materially affected the eventual
allocation of capital between the bidders and the principles of the hedge fund. Or
wonder whether the intervention prolonged or reduced the pain of dealing withthe situation.
In sum, even if we all agree that a large financial institution may be “too big toliquidate,” the nature and timing of interventions, if any, by regulatory agencies is
a complex issue. And the question of whether recent interventions were socially
optimal is one that seems to have not yet been fully addressed. More generally, on
the issue of systemic risk, the non-linearity associated with default and illiquidity
is an issue that was not given the same attention that was given to the issues ofsystemic risk in settlement and banking systems. I hope that more attention will
be devoted to these securities market issues at the next Central Bank Conference.
Finally, the central banks hosting this conference, and the Bank of Japan inparticular, have done a wonderful job in organizing this conference. Participation
has certainly helped me think through the many important issues that have been
discussed over the last two days.