Donald L Kohn: The evolving nature of the financial system - financial crises
and the role of the central bank
Remarks by Mr Donald L Kohn, Member of the Board of Governors of the US Federal Reserve
System, at the Conference on New Directions for Understanding Systemic Risk, New York, 18 May
2006.
* * *
I am very pleased to participate in a conference seeking new directions for understanding systemic
risk. Let me begin by thanking the Federal Reserve Bank of New York for hosting the conference and
for organizing, along with the National Academy of Sciences, an impressive program that will facilitate
interdisciplinary discussion on a topic of intense interest to central bankers.1
The evolution of institutions and markets
Maintaining the stability of the financial system and containing the systemic risk that may arise in
financial markets has been central to the Federal Reserve's mission for as long as there has been a
Federal Reserve. Indeed, Congress passed the Federal Reserve Act in 1913 to provide the nation with
a safer and more stable monetary and financial system.
Thus, the focus of this conference--understanding systemic risk--is not new, though some of the
names have changed. At the beginning of the twentieth century, banks were virtually the only financial
intermediary available. Periodically, these highly leveraged institutions lost the confidence of
depositors, fell into crisis, and reduced their lending to creditworthy borrowers, thereby accentuating
economic downturns. The tools that were developed to prevent and to manage financial
crises-lender-of-last-resort facilities, supervision and regulation aimed at bank safety and soundness, deposit
insurance, and the provision of payment system services--were geared toward a bank-denominated
system.
Today, multiple avenues of financial intermediation are available, and the financial system has
become much more market-dominated. This evolution of financial institutions and markets probably
has made the financial system more resilient. Financial innovations, such as the development of
derivatives markets and the securitization of assets, have enabled intermediaries to diversify and
manage risk better. Moreover, as markets have become more important, ultimate borrowers have
acquired more avenues to tailor their risk profiles and are less dependent on particular lenders, and
savers have become better able to diversify and to manage their portfolios. Consequently, the
economy has become less vulnerable to problems at individual types of institutions.
However, the evolution of financial institutions and markets has not removed the underlying risks and
uncertainty associated with financial transactions. Financial institutions and other market participants
must still make decisions and take actions with incomplete knowledge about the condition of their
counterparties. Actual (or perceived) information asymmetries can increase enormously during times
of heightened market volatility or economic stress. In addition, in such circumstances, investors may
become very uncertain about the behavior of other market participants and the resulting path of asset
prices and extent of market liquidity, creating a situation in which each market participant waits to see
how other investors will react.
When this happens, the typical correlations derived from historical experience tend to break down,
liquidity may be more costly to obtain or unavailable, normal risk management strategies may no
longer be useful, questions about counterparty solvency escalate, and the result can be a financial
crisis. In times of such high uncertainty, it is human nature to act very cautiously. Investors uncertain
about what shocks other market participants have experienced and unsure about what those other
market participants are likely to do tend to withdraw from potentially risky financial activities and to
hold safer and more liquid assets, such as government securities.
As a consequence, creditworthy borrowers may not be funded, just like in the old days when banks fell
into crisis. These disruptions in the flow of credit in turn can have real effects on the macroeconomy.
Moreover, these real effects can create feedback effects on market participants that exacerbate the
original financial crisis.
These motivations and reactions persist in the twenty-first century, and thus so does the possibility of
financial crisis, even if the key propagation mechanisms for crisis in our financial system may have
changed. The shift from a bank-dominated financial system to a combination of centralized and
decentralized markets has increased the importance of market liquidity for determining asset prices
and for managing portfolios. The increased importance of markets also has created new and complex
interactions among participants in the financial system and heightened the reliance on key market
utilities.
We are in the process of adapting the tools that were developed to prevent and manage financial
crises in a bank-dominated financial system to prevent and manage financial crises in the more
market-dominated financial system. This is an ongoing process that is very much informed by our
experience with past financial crises. In that regard, the 1987 stock market crash and the liquidity crisis
in the fall of 1998 are likely to be more typical of modern financial events. In the rest of my talk, I will
discuss the following aspects of these two events: their common elements, the Federal Reserve's
response, lessons learned for crisis management, and implications for crisis prevention in the more
market-driven financial system.
Two modern financial crises
The 1987 stock market crash may have been the first modern financial crisis in the United States.
Unlike previous financial crises, the 1987 stock market decline was not associated with a deposit run
or any other problem in the banking sector. Instead, the 20 percent decline on October 19, 1987, in
the Standard & Poor's 500 index--the largest single-day decline since the Great Depression--was
driven by investor decisions to reduce equity exposures and by the resulting chaotic trading in the
stock markets. Indeed, trading was so chaotic that stock prices were difficult to determine.
The liquidity crisis in the fall of 1998 was triggered by the Russian debt default in August and then
aggravated by the problems at the hedge fund Long-Term Capital Management. During the 1998
crisis, risk spreads widened sharply, stock prices fell, and liquidity became so highly valued that the
spread between on- and off-the-run Treasury securities widened substantially. Of even more concern,
the capital markets virtually seized up as market participants retreated from risk taking, and, for a time,
credit was simply unavailable to many private borrowers at any price.
The events of 1987 and 1998 had several common elements. First, they began with sharp movements
in asset prices. Second, these price movements were exacerbated by market participants trying to
protect themselves--with portfolio insurance in 1987 and by closing out positions in 1998. Third,
market participants became highly uncertain about the dynamics of the market, the "true" value of
assets, and the future movement of asset prices. As a consequence, with their standard
riskmanagement systems seemingly inapplicable, they pulled back from making markets and taking
positions and further exacerbated the price action. Fourth, the large and rapid price movements called
into doubt the creditworthiness of counterparties, which could no longer be judged by now obsolete
financial statements; credit decisions were further complicated by uncertainty about the value of
collateral. In turn, the defensive behavior of market participants escalated and reinforced adverse
market dynamics. Finally, the decline in asset prices reduced wealth and raised the cost of capital,
which seemed likely to reduce both consumption and investment.
Naturally, the Federal Reserve's response to these crises also had several common elements. We
publicly acknowledged that a crisis was under way, and through this recognition and our follow-up
actions, we sought to reassure participants that we were doing what we could to limit the possible
systemic effects on the economy. The hope was that such reassurance might encourage a return to
risk-taking. Accordingly, open market operations were directed toward an easing of reserve-market
conditions and were guided by day-to-day developments. For example, in October 1987, open market
operations accommodated substantially enlarged desires for excess reserves and a large increase in
required reserves associated with a sharp rise in transactions deposits. We monitored the flow of
credit through the financial system, and we pointed out to lenders their collective interest in avoiding a
credit gridlock that would only tend to accentuate asset price movements. We worked with other
agencies to identify weak points in the market and impediments to its functioning. We also eased the
stance of monetary policy to counteract the systemic consequences of the ongoing financial crisis.
Principles to be drawn from recent financial crises
What are the principles for Federal Reserve actions that we can draw from these experiences, as well
as from other recent, but less severe periods of financial turmoil? First and foremost, the management
of financial crisis is easier, and the consequences are less severe, if the economy is in healthy
condition. Partly as a consequence in neither 1987 nor in 1998 did the crisis lead to a recession. As
monetary policy makers, we improve the odds of financial stability over time when we focus on the
fundamentals of maintaining price stability and sustainable growth. When the Federal Reserve
conducts monetary policy so as to create low and stable inflation and to firmly anchor expectations
that inflation will be contained, it best positions itself to forcefully offset the ill effects of a financial crisis
without generating deep concerns that such actions will result in sharply higher inflation. Some argue
that economic stability can set the stage for financial instability by breeding complacency about risk.
Perhaps, but surely the benefits of macroeconomic stability far outweigh its possible costs.
Another principle is that a healthy banking system works hand-in-hand with a healthy economy to
substantially mitigate the consequences of financial crisis. Banks continue to play critical roles in the
market-dominated system, including financing market participant's holdings of securities and clearing
and settling their trades. Healthy banks can be bulwarks against the propagation of financial turmoil; in
contrast, questions about the health of banks would raise additional concerns during the course of a
crisis.
A third principle is that the actions taken to prevent a crisis should not raise the odds of creating more
problems in the future. In particular, the problem of moral hazard is a significant concern. If market
participants begin to rely too much on regulators and central bankers to manage possible future crises,
they may act in a way that has the effect of raising the risk of a financial crisis. For example, they may
fail to engage in adequate due diligence when extending credit to other market participants or to
maintain adequate capital for the risks they undertake. And they might come to believe that the
government possesses more tools and resources than are actually available to shield them from the
consequences of poor risk management.
The central bank can draw from a menu of actions that involve varying degrees of moral hazard.
Those actions range from loans to individual institutions that otherwise would not have access to
credit, to moral suasion, to open market operations, which allow the markets to distribute credit and
should not cause distortions in private-sector decisionmaking.
Heightened uncertainty is the key characteristic of episodes of financial instability. The central bank
may not have any more information than market participants do; in economic models based on such
uncertainties, it is the central bank's willingness to act in the face of uncertainty that differentiates it
from other market participants and gives it a positive role to play during financial crises. Its willingness
to act ameliorates the negative effects of the uncertainty of other market participants about the
solvency of counterparties and the status of markets.
Still, the more information the central bank has, the easier it is for it to choose the best course of
action. Policymakers want to choose the path with the lowest moral-hazard consequences to leave
market participants with incentives to manage risk appropriately. But policymakers are in a difficult
position in a crisis. The costs of not acting forcefully enough will be immediate and obvious--additional
disruption to the financial markets and the economy. The costs of acting too forcefully--of interfering
unnecessarily in markets and creating moral hazard--manifest themselves over a longer period and
may never be traceable to a particular policy choice. The natural inclination to take more intrusive
actions that minimize the risks of immediate disruption 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 may well color the information they are giving you.
In a bank-dominated financial system, the critical information would have come from fellow bank
regulators with whom we had been working or from the institutions we collectively had been examining
for some time. In a world of financial institutions with a presence in many lines of business crossing
national boundaries, obtaining such information, developing cogent analyses, and deciding on a
course of action in a crisis requires widespread cooperation among many disparate agencies.
Moreover, I should note that, even for possible bank-centric crises, the financial landscape in the
United States has changed. The large bank holding companies are involved in a myriad of businesses
that cross a multitude of regulatory boundaries. In addition, any future financial crisis that does involve
a large, complex banking organization might need to grapple with the "systemic risk exception" that
was passed by the Congress in 1993, which requires the boards of the Federal Reserve and of the
Federal Deposit Insurance Corporation, the Secretary of the Treasury, and the President to act jointly.
Establishing the needed coordination across many agencies could potentially create delays during a
time when quick action is needed. Moreover, different regulators can have different supervisory
philosophies. These potential impediments to a timely response suggest that regulators need to be
discussing the possibilities associated with financial crisis on an ongoing basis and long before an
actual event. These discussions should encompass the possible actions that might be needed and the
information that should be on hand to shape those actions in the public interest.
Reducing the odds on financial crises
This brings me to my final and most important principle--an ounce of prevention is worth many pounds
of cure. As we've seen in recent years, macroeconomic stability has not forestalled large and
unexpected movements in asset prices. Shocks occur, or reality catches up to unreasonable
expectations, and market prices adjust, sometimes very substantially and suddenly. And although the
financial system has become more resilient to such unanticipated developments, it is still subject to
bouts of increased uncertainty that could build on themselves to disrupt the normal functioning of
markets and send asset prices further away from fundamentals, with potentially adverse implications
for the economy. Drawing on our experiences, the Federal Reserve has been working with other
regulatory agencies and the private sector both here and abroad to strengthen the financial system in
order to lower the odds that a sharp change in prices or questions about a major market participant
would lead to a systemic financial crisis. Our collective efforts have been in three areas: enhancing
market discipline; encouraging sound risk management; and strengthening clearing and settlement
systems.
Market discipline through vigilance among private parties is always to be preferred to regulatory
dictates as the prime source of constraint on possible crisis-causing behavior. It lessens the odds of a
financial crisis and any potential moral hazard that might be created by governmental actions taken
during periods of financial market turmoil. Reliance on market discipline becomes even more of an
imperative when key market participants are subject to widely varying degrees and types of regulation
from different regulators. For market discipline to be effective, counterparties must have a clear
understanding of each others' risk profile. Such transparency can be promoted through sound policies
regarding accounting and, where necessary and appropriate, public disclosure. However, a
meaningful understanding of risk profiles often requires information that market participants regard as
proprietary. Confidentiality agreements between counterparties may be necessary to make them
comfortable sharing such information. Counterparties that cannot obtain sufficient information should
limit more strictly the amount of credit they supply through, for example, requiring higher margins.
In a market-based system, sound risk management by all market participants is essential to protect
against the risk that a low-probability--or "tail"--event could cause a financial crisis. Such practices
enhance financial stability without increasing moral hazard. Indeed, sound risk management by all
market participants would reduce moral hazard. Market participants familiar with the risk metrics, the
stress-test methodologies (and the associated market scenarios), the models, and other analytics
used by their counterparties' risk managers would be more likely to continue to provide access to
credit during periods of systemic and institutional stress. Of course, the more that privately provided
credit continues to flow in such circumstances, the lower the odds on a crisis and on the need for
government intervention.
It is a tall order to "plan" for the unexpected, improbable, and unknowable nature of future financial
market crisis, but actions by the authorities, such as supporting risk-management policy groups and
promoting stress-testing, should help. For example, bringing together practitioners can potentially
improve both the markets' and the central bank's understanding of how leverage, liquidity, and
concentration are interrelated. In addition, risk-management policy groups can potentially lead to
improvements in the reporting of risk information to counterparties and allow for the transfer of best
practices across market participants with respect to valuation, exposure measurement, limit setting,
and internal checks and balances. Indeed, a lesson drawn by the President's Working Group from the
1998 crisis was that a lack of basic risk management, and the resulting ability of risk managers to
avoid counterparty discipline, was an important factor that enabled key market participants to become
so large that their troubles could disrupt entire markets.
Stress tests employ either historical data from asset price distributions or hypothetical scenarios that
would provide insights into the downside financial risks associated with investments and associated
hedging strategies. Focusing market participants on the structure of stress, and thus their risks beyond
the range of recent historical experience, might assist in limiting the affects of a highly infrequent but
significantly costly tail event.
The regulatory capital framework proposed in Basel II would require the largest internationally active
banking organizations to enhance measurement and management of their risks, including credit risk
and operational risk. It would also require these entities to have rigorous processes for assessing
overall capital adequacy in relation to their total risk profile and to publicly disclose information on their
risk profile. Because such actions would likely provide market participants with a better sense of how
others might act during a crisis, these actions would likely help mitigate the adverse consequences
created by financial market turmoil.
Risk cannot be managed if participants are uncertain about their exposures to counterparty credit risk
and to changes in prices. It is important for trades to be cleared and settled when expected at the
agreed upon price with the anticipated counterparties. As a result, the central bank must promote
robust payment and settlement systems. Sound risk-management practices and stress testing by
operators of the settlement infrastructure are critically important in this domain. If payment and
settlement systems have adequate collateral and liquidity to settle during turbulent periods, they
reduce the threat of contagion across institutions and markets. To this end, the Federal Reserve
actively participates in international groups, such as the Committee on Payment and Settlement
Systems, that identify and promulgate best practices.
Counterparty discipline, sound risk management, and strong and resilient clearing and settlement are
all in the interest of private parties. Nonetheless, government has a role to play, especially when it
senses moral hazard is weakening market discipline on risk taking and leaving the broader interests of
society inadequately protected. Regulators may need to insist on minimal capital levels and on actions
to strengthen private systems. In addition, they may need to work with disparate private parties and
help market competitors take collective actions to solve problems that such competitors might
otherwise find difficult to solve by themselves. For example, the Federal Reserve Board recently
endorsed the chartering of a dormant bank, referred to as NewBank, which would be available for
activation to clear and settle U.S. government securities. Such activation would occur if an existing
clearing bank could not operate and no well-qualified bank stepped forward to purchase its clearing
business. Similarly, the Federal Reserve Bank of New York, and other regulatory bodies have met with
major dealers to strengthen the clearing and settlement infrastructure for the credit derivatives
markets.
Conclusion
Maintaining the stability of the financial system and containing the systemic risk that may arise in
financial markets is central to the Federal Reserve's mission. Recent financial crises within the United
States have been well contained. However, with the rapid evolution of the financial system, there is a
real possibility that markets are evolving faster than the efforts by market participants to better control
risk and to improve the payment and settlement infrastructure.
New markets have been tested to some extent--by the stock market crash, by the widening of spreads
in 2001 and 2002, and by the problems of the auto companies and their suppliers. So far, despite
some glitches, markets have adapted and changed when deficiencies became obvious. No doubt,
markets and institutions have become more flexible and resilient. But perhaps we have also been
lucky; prudence dictates that we identify points of weakness and strengthen them.
And, in a rapidly evolving financial system, we need to think creatively about where the weakness
might be and how disturbances might be transmitted and amplified. Thus, this conference has the
potential to contribute materially to our ability to continue to fulfill our most basic mandate: To foster an
efficient, stable financial system in support of our nation's economic welfare.