Donald L Kohn: Crisis management - the known, the unknown, and the
unknowable
Remarks by Mr Donald L Kohn, Member of the Board of Governors of the US Federal Reserve
System, at the Wharton/Sloan/Mercer Oliver Wyman Institute Conference, "Financial Risk
Management in Practice", Philadelphia, 6 January 2005.
* * *
In pursuing its policy objectives, a central bank must make decisions in the face of uncertainty related
to incomplete knowledge about the evolving condition of the economy and the financial system as well
as about the potential effects of its actions. This uncertainty implies that the central bank must
incorporate into its decisions the risks and consequences of several alternative outcomes. That is, it
needs to assess not only the most likely outcome for a particular course of action but also the
probability of the unusual - the tail event. And it needs to weigh the welfare costs of the possible
occurrence of those tail events.
This risk-management approach has been articulated by Chairman Greenspan for monetary policy,
and it is equally applicable to a central bank's decisions regarding crisis management, the topic I will
focus on today.1 Crises are themselves tail events, and the policy response to them is focused on the
possibility and cost should the outcome be especially adverse.
As I am sure we will hear time and again today, knowledge - reliable information - is essential to
managing risks. In a financial crisis, however, information inevitably will be highly imperfect. The very
nature of a crisis means that the ratio of the unknown and unknowable will be especially large relative
to the known, and this, in turn, can influence how policymakers judge risks, costs, and benefits.
Although the subject of my contribution to this panel is crisis management, I want to emphasize at the
outset that the far-preferable approach to financial stability is to reduce the odds on such crises
developing at all. To this end, central banks seek to foster macroeconomic stability, encourage sound
risk-taking practices by financial market participants, enhance market discipline, and promote sound
and efficient payment and settlement systems. In this arena, an ounce of prevention is worth many
pounds of cure. Before going further, I should say that the views I will express today are my own and
not necessarily those of other members of the Board of Governors or its staff.2
Costs, benefits, and policy options
But even prevention has costs that must be weighed along with its benefits. No financial system that is
efficient and flexible is likely to be completely immune from episodes of financial instability from time to
time, and policymakers will be forced to make judgments about the costs and benefits of alternative
responses with very incomplete information.
In a financial crisis, the potential cost of inaction or inadequate action is possible disruption to the real
economy, which would damp activity and put undesirable downward pressure on prices. Such
disruptions can come about because crises heighten uncertainty about the financial status of
counterparties and about the eventual prices of assets. In an especially uncertain environment,
lenders may become so cautious that credit supplies are cut back more than would be justified by an
objective assessment of borrowers' prospects; concerns about counterparty risk can impair the
smooth functioning of payment and settlement systems, interfering with a wide variety of markets;
asset prices can be driven well away from equilibrium values; and confidence can be undermined.
These types of tail events could depress economic activity for a time and, if prolonged, could also
adversely affect efficiency and productivity by impairing the ability of financial markets to channel
savings into the most productive investments.
Although policy action may be able to reduce the odds of adverse effects or alleviate their impact,
some policy responses to a crisis can themselves have important costs that need to be balanced
against their possible benefits. In short, intervening in the market process can create moral hazard and
weaken market discipline. If private parties come to believe in the possibility of policy actions that will
relieve them of some of the costs of poor decisions or even just bad luck, their incentives to
appropriately weigh risks in the future will be reduced and discipline on managers watered down.
Weaker market discipline distorts resource allocation and can sow the seeds of a future crisis.
The possible real costs of policy actions implies that they should be taken only after the determination
that, in their absence, the risk is too high that the crisis will disrupt the real economy. Once that
judgment is reached, the central bank and other authorities have a variety of instruments to use, and
the degree of potential moral hazard created will depend on the instrument chosen.
Approaches that work through the entire market rather than through individual firms run a lower
probability of distorting risk-taking. Thus, a first resort to staving off adverse economic effects is to use
open market operations to make sure aggregate liquidity is adequate. Adequate liquidity has two
aspects: First, we must meet any extra demands for liquidity that might arise from a flight to safety; if
they are not satisfied, these extra demands will tighten financial markets at exactly the wrong moment.
This was an important consideration after the stock market crash of 1987, when demand for liquid
deposits raised reserve demand; and again after 9/11, when the destruction of buildings and
communication lines impeded the flow of credit and liquidity.
Second, we must determine whether the stance of monetary policy has to be adjusted to counteract
the effects on the economy of tighter credit supplies and other consequences of financial instability.
Policy adjustments also can help head off some of those effects in that, by showing that the central
bank recognizes the potential seriousness of the situation, they bolster confidence. As a consequence,
meetings of the Federal Open Market Committee (FOMC) - often in conference calls if the situation is
developing rapidly - have been an element in almost every crisis response. Those meetings allow us
to gather and share information about the extent of financial instability and its effects on markets and
the economy as we also discuss the appropriate policy response.
Some critics have argued that the FOMC's policy adjustments in response to financial instability
encourage undue risk-taking in the financial markets and the economy. However, to the extent that the
conduct of policy successfully cushions the negative macroeconomic effects of financial instability, it
genuinely lowers risk and that fact should be reflected in the behavior of private agents. Other
instruments to deal with instability - discount window lending, moral suasion, actions to keep open or
slowly wind down ailing financial institutions - are much more likely than monetary policy adjustments
to have undesirable and distortionary effects on private behavior. By making credit available to
individual firms on terms more favorable than would be available in the market, or by affording a
measure of protection to existing creditors, these other instruments carry substantial potential for
moral hazard. Hence, they are and should be used only after a finding that more generalized
instruments, like open market operations, are likely to be inadequate to stave off significant economic
disruption.
If it is determined that actions to support the credit of specific firms are necessary, such actions should
be designed to minimize moral hazard. Sometimes moral suasion will be sufficient - simply by calling
attention to the potential consequences of withholding payments or credit, private parties may be
persuaded that avoiding such an outcome is in their self-interest. But central banks must be careful
that moral suasion is not perceived as coercion or an implied promise of official indemnification for
private losses. If the central bank concludes that it must lend to individual depository institutions to
avoid significant economic disruption, in most situations any such loans should be on terms sufficiently
onerous to discourage reliance on public-sector credit.
The Federal Reserve tries to find the approach that reduces the odds on economy-wide spillover
effects while interfering as little as possible with the market and allowing people and institutions to
suffer the consequences of decisions that turn out to be bad. Nearly every major bout of financial
instability has called for some degree of monetary easing - most often only temporarily until the threat
of the low-probability but high-cost economic disruption has passed. Other tools have been used
occasionally, and an assessment of their costs and benefits has depended on the nature of the crisis.
Moral suasion was an element in dealing with the panicky private-sector actions associated with the
sharp and apparently self-feeding market price breaks of 1987 and 1998. Lending through the
discount window helped to promote an orderly unwinding of distressed institutions in the period of
prolonged and widespread problems among important intermediaries in the late 1980s and early
1990s. And such lending was crucial in getting liquidity to the right places after the disruption of 9/11.
In each case, the nature of the response has depended on the state of the economy and financial
markets before the event. When the economy is strong and financial systems robust, a shock to the
financial system is less likely to feed back on the economy.
Information flows in a crisis
Clearly, judgments in a crisis must balance a number of difficult considerations in rapidly changing
circumstances in which up-to-date, accurate, information is scarce.
Our experience suggests some of the key questions that might arise when confronting a crisis: how
large is the financial disruption - how many firms or market participants are involved and how large are
they? What is the potential for direct and indirect contagion, both domestic and international? Who are
the counterparties and what is their exposure? Who else has similar exposures and might be
vulnerable to further changes in asset prices that could be triggered by a firm's failure and unwinding
of positions? How long are the financial disruptions likely to last? Are substitute providers of financial
services available, and how easily and quickly can they be employed? And, critically, what are the
initial and expected states of the macroeconomic and financial environments under various scenarios?
Coming to grips with these questions requires a considerable amount of detailed, up-to-the-minute
information - more than can be known ahead of time. Even in the best of circumstances, much of the
information on variables relevant to decisions about whether or how to intervene will be unknown
(especially if a crisis materializes quickly) or unknowable. Published balance sheets and income
statements - or old examination reports - give only a starting place for analysis when asset prices and
risk profiles are changing rapidly and in ways that had not been anticipated. In addition, crises
invariably reveal previously unknown interdependencies among financial intermediaries and among
intermediaries and the ultimate suppliers and demanders of funds.
Central banks and others that might be involved in crisis management must take steps to push back
the frontiers of the "unknown" before a crisis hits and to develop procedures for obtaining the
"knowable" quickly when needed. More information is not just a "nice to have." Policymakers want to
choose the path with the lowest moral hazard consequences. But they are in a difficult position in a
crisis. The costs of not acting forcefully enough will be immediate and obvious - additional disruption to
financial markets and the economy. The costs of acting too forcefully - of interfering unnecessarily in
markets and creating moral hazard - manifest themselves only over a longer time and may never be
traceable to a particular policy choice. The natural tendency to take more intrusive actions that
minimize the risk of immediate disruptions is probably exacerbated by ignorance and uncertainty; the
less you know, the easier it is to imagine bad outcomes and the more reliant you may be on people in
the market whose self-interest inevitably colors the information they are giving you.
Each episode of financial instability is different and teaches us something new about what information
is useful and who needs to call whom to share information. For example, clearing mechanisms for
futures and options were an issue in the 1987 crash; capital impairment of depositories, its effect on
lending, and the response of regulators took center stage in the late 1980s and early 1990s; the
importance of market liquidity came to the fore in 1998 when even the prices of off-the-run Treasury
securities took a beating; and physical infrastructure issues dominated developments after the terrorist
attacks on 9/11.
Although a knowledge base is helpful, the answers to the questions I posed earlier will depend
critically on a free flow of new information. In a world of financial institutions with a presence in many
lines of business crossing national boundaries, obtaining such information and developing cogent
analysis requires widespread cooperation among many agencies. The Federal Financial Institutions
Examination Council - in which all U.S. depository institution regulators participate - is a forum for
developing information and relationships within the regulatory community. The President's Working
Group itself was a product of the 1987 stock market crash, which revealed a need for better
communication and coordination among all financial regulators. In addition, we build bilateral
relationships with foreign authorities through participation in various international groups, such as the
Basel Committee on Banking Supervision, the Committee on Payment and Settlement Systems, the
Financial Stability Forum, and so on. A number of the phone calls I made and received in the hours
and days after 9/11 were with people in other central banks with whom I had established working
relationships on monetary policy groups or in international preparations for Y2K. But although
agencyto-agency communication is important, it is in a sense only a secondary source of information. The
primary and best sources are the contacts we all develop with major financial participants as we carry
out our daily operations and oversight responsibilities.
Whatever the origin of the crisis, the Federal Reserve has usually found itself near the center of the
efforts to assess and manage the risks. To be sure, we have some authorities and powers that other
agencies do not. But in addition, we bring a unique perspective combining macro- and microeconomic
elements that should help us assess the likelihood of disruptions and weigh the consequences of
various forms of intervention. Because of our responsibility for price and economic stability, we have
expertise on the entire financial system and its interaction with the economy. Central banks need to
understand - to the limited extent anyone can - how markets work and how they are likely to respond
to a particular stimulus. Our role in operating and overseeing payment systems gives us a window into
a key possible avenue for contagion in a crisis. At the Federal Reserve, our supervisory
responsibilities provide us with knowledge of the banking system and the expertise to interpret
information we get from other agencies. We have people at the Board and Reserve Banks who are
expert in macroeconomics, in banking, in payment and settlement systems, and in various financial
markets, and all have market contacts; our colleagues at the Federal Reserve have proven to be our
best source and filter of information in the midst of a crisis.
Despite our efforts, much will still be unknown and some things will be unknowable as we make
decisions in a crisis. Financial instability is by definition a tail event, and it is the downside possibilities
of that tail event that concern the authorities. Market participants are reacting under stress, on
incomplete and often false information, in situations they have not faced before. Uncertainty - in the
Knightian sense of unquantifiable risk - is endemic in such situations. Uncertainty drives people to
protect themselves - to sell the asset whose price is already declining, to avoid the counterparty whose
financial strength might conceivably be impaired, to load their portfolios with safe and liquid assets.
Market mechanisms are tested in ways that cannot be modeled ahead of time.
Contagion is always a key underlying issue in trying to assess the potential for sustained disruption of
the financial system and the economy. Contagion, in turn, is partly a question of psychology - how will
people react under conditions of stress? So, too, is moral hazard - once the stressful situation passes,
how will people adapt their behavior as a consequence of any intervention? Thus, much of the most
desirable information is "unknowable" in any quantitative sense. The authorities must rely, therefore,
on judgment, based on experience and on as much information as can be gathered under adverse
circumstances.
The changing financial system and the known, the unknown, and the unknowable
The evolution of financial markets and institutions over recent years may well have made the financial
system more resilient and reduced the need for intervention. The lowering of legal and regulatory
barriers across financial services and geography, the development of derivative markets, and the
securitization of so much credit has enabled intermediaries to diversify and manage risk better,
reduced the number of specialized lenders who would be vulnerable to sector- or area-specific shocks,
and left borrowers far less dependent on particular lenders and consequently the economy much less
vulnerable to problems at individual or even classes of institutions.
In the past few years, the financial markets have come through an extraordinarily stressful period, but
one that was not marked by the sort of financial-sector distress that accompanied and intensified the
economic problems in many previous such episodes. I attribute that relatively good record, in no small
part, to greater diversification of risk, to the growing sophistication of risk management techniques
being applied at more and more institutions, and to stronger capital positions going into the period of
stress.
This may be the typical experience in the future; one hopes so, and the regulators are working in
various ways to make it so - through the Basel II effort as one prominent example. But, unfortunately,
we cannot count on that outcome. Crises remain a threat, and the increasing complexity of the
financial system and of the laws governing it are affecting how crises are likely to be managed. The
greater variety and utilization of risk transfers will put new demands on information flows to answer the
questions I posed earlier. The growing reach of major financial institutions across industry boundaries
and national borders is increasing the necessity for cooperation and coordination among regulators
here in the United States and around the world. At the same time, institutions manage risk on an
integrated basis and understanding and dealing with the effect of financial instability and the feedback
of their actions on markets and other institutions will call for an integrated overview.
No institution can be "too big to fail." Handling the failure of a large, complex organization - imposing
the costs of failure on management, shareholders, and uninsured creditors while minimizing the
effects on the wider economy - will certainly be complicated. But we cannot allow the public interest in
containing moral hazard to be held hostage to complexity. Indeed, U.S. law requires that we do not. In
dealing with the failure of an insured depository institution, the authorities are required to use the
method that yields the least cost to the insurance fund unless they find that the least-cost method
entails systemic risk and that a more costly method would mitigate that risk. In setting out a procedure
to follow in such circumstances and holding authorities explicitly accountable for their decisions
against a reasonably clear set of objectives, the law puts a premium on preparing for the type of
analysis that will be needed. The Federal Reserve is in continuing conversations with other agencies
on approaches to these issues.
The growing complexity of institutions elevates the importance of avoiding crises, rather than
managing them. We must continue to adapt our supervision of financial institutions and payment
systems to encourage and reward good risk management and enhance market discipline.