Select Committee on Treasury Written Evidence

Memorandum from E Gerald Corrigan, Goldman Sachs

  The purpose of this statement is to provide a brief summary of my long-held personal views on two closely related subjects; namely (1) systemic financial risk; and (2) the so-called moral hazard dilemma associated with efforts by public authorities to mitigate such systemic risks.


  1.  Financial shocks are distinguished from financial disturbances

    (1a)  Financial shocks have the potential to inflict serious damage on the financial system and/or the real economy.

    Financial shocks are relatively infrequent.

    (1b)  Financial disturbances occur with some regularity but typically are sorted out by the marketplace with limited disruption or damage.

  2.  Recent history and the long sweep of financial history point to four inescapable conclusions about systemic financial shocks:

    (2a)  First, on balance, the already low statistical probabilities of the occurrence of financial shocks have declined further in recent years, even if such probabilities are still well short of zero.

    (2b)  Second, given the speed, complexities and linkages of contemporary financial markets, the potential for damage caused by financial shocks is greater than in the past even if the probability of occurrence is lower.

    —  Stated differently, the threat of contagion is greater.

    (2c)  Third, our collective capacity to anticipate the specific timing and triggers of financial shocks is essentially nil.

    —  To cite a recent example, in the spring of this year almost everyone recognised that credit terms and credit spreads were likely to adjust to more normal standards.

—  But, human nature being human nature, when markets are robust there is a natural aversion to being the last one in or the first one out.

—  In other words, we sometimes forget that financial market behavior is fundamentally a manifestation of collective human behavior with all of the frailties associated with human behavior. That is why from time-to-time financial markets will overshoot in both directions.

    (2d)  Fourth, because of the three factors cited above, financial market practitioners and policymakers have no choice but to focus unrelenting attention on what I like to call strengthening the "shock absorbers" of the global financial system.

    —  The term shock absorber as used in this context has a very broad meaning in that it applies to the full range of private and official initiatives designed to enhance the stability of the financial system including the key elements of the so-called "public safety net" associated with banking institutions such as official supervision, access to the credit facilities of the central bank and deposit insurance.

    —  And, despite the recent turmoil in credit markets, I believe solid progress is being made in strengthening these shock absorbers even as financial practices become more complex and relatively new classes of financial institutions take on an increasingly important role in the financial intermediation process.

  3.  Having made the distinction between financial shocks and financial disturbances, the events of the last several months clearly qualify as a financial shock with clear elements of systemic risk. That being the case, there follows a few broad observations regarding the causes of the current financial shock.

  4.  At one level, it is abundantly clear that the proximate cause or trigger of recent financial events was the excesses in the housing sector in the United States with emphasis on the sub-prime mortgage market.

    (4a)  More fundamentally, it is equally clear—at least with the benefit of hindsight—that the "reach for yield" phenomenon spurred by a long period of abundant liquidity and relatively low interest rates helped to stimulate a surge in the creation and use of multiple forms of structured credit products, many of which are very complex. Often, these structured credit products provided institutional investors access to investment opportunities providing relatively high returns but with correspondingly high risks.

  5.  Even in the face of early signs of problems in the sub-prime market such as the HSBC acknowledgement of large sub-prime credit losses in February of this year, I think it is fair to say that many observers were slow in recognising the potential scale of the housing and sub-prime mortgage problem and its potential contagion effects.

    (5a)  It was probably the losses experienced by the Bear Stearns hedge funds in the early summer that brought the problem into sharper focus and served as the wake up call as to the serious nature of the problem and its potential to unleash damaging contagion risk forces.

  6.  Looked at more broadly, the market turmoil that followed seems to have been driven by two fundamental forces, both of which had important implications for the contagion phenomenon. At the risk of oversimplification, those two fundamental forces were as follows:

    (6a)  First, we experienced a broad-based drive to re-price credit risk which took hold across broad segments of the credit markets that were by no means limited to sub-prime mortgages. The motivation associated with the market-driven effort to re-price credit risk was to enhance and strengthen credit terms from the perspective of credit suppliers.

    (6b)  Second, in a separate but related development, we witnessed a simultaneous drive across all classes of financial institutions to reduce risk.

  7.  The drive to re-price credit and to reduce risk in the face of changing market conditions is hardly a new phenomenon. But, in recent weeks and months there were factors at work that made this phenomenon different in degree—if not kind—from earlier episodes. I would cite two factors that at least in degree were different from earlier experience and thus, elevated contagion risk factors. They are:

    (7a)  First, the credit re-pricing process was hindered by the break down in the price discovery process for some classes of complex financial instruments including but not limited to sub-prime mortgages and their derivatives such as CDOs (collateralized debt obligations). And, as the markets for such instruments became illiquid, the price discovery process was further impaired. Obviously, if price discovery is not working, re-pricing credit suffers accordingly.

    (7b)  Second, risk reduction, which necessarily entails reducing position risk and/or leverage, inevitably brings with it added pressures on market liquidity which, in turn, contributes to increased volatility and higher risk premiums. Ironically, such increases in volatility also increase measured risk, thus frustrating efforts to reduce risk. Indeed, I suspect that for many institutions, increases in volatility were largely offsetting efforts aimed at position reduction such that key risk metrics such as "value at risk" were little changed, or may have increased, despite meaningful reductions in position risk and leverage. This phenomenon is not new, but in the face of uncertainties about the value of some financial instruments as discussed above, it certainly did aggravate the turmoil in credit markets.

    (7c)  This analysis leads us inevitably to a troubling conclusion: namely, while experience and history allow us to identify certain common denominators associated with most financial shocks, the specific triggers and transmission channels that produce contagion are almost always impossible to anticipate with any meaningful degree of precision. Thus, no matter how smart we think we are, crisis management for practitioners and policymakers alike will always take place in a setting of sizeable gaps in hard information and great uncertainty as to how contagion factors will play out.


  8.  Intervention by central banks and/or governments in the face of financial crises has been a fact of life for centuries. Not surprisingly, concerns about moral hazard—or the risk that such interventions will protect institutions and investors from loss thereby sowing the seeds for even greater excesses in the future—have also been a fact of life throughout financial history.

    (8a)  While the moral hazard problem is very real, there clearly are extreme circumstances in which official intervention by central banks and other official bodies to mitigate the damage caused by financial crises are justified.

    —  That is the primary reason why many central banks were created.

    —  Moreover, looking at the history of such interventions over the past two or three decades, it can hardly be said that such interventions have protected institutions and investors from losses. For example, the write-downs experienced by a number of major financial intermediaries in recent weeks have now reached tens of billions of dollars and the meter is still running.

    (8b)  Thus, the issue is not whether circumstances may arise from time-to-time in which official intervention is wholly justified but rather (1) the skill and discipline with which central banks and others make the judgment that intervention is justified; and (2) the timing and manner in which that judgment is exercised.

    —  It is important to keep in mind that just as there are consequences of a judgment to intervene, there are also consequences of not intervening.

    —  The decision to intervene, or not, must always be made on the basis of imperfect information and considerable uncertainty. However, in my experience from the perspective of a professional life in both the public and private sectors, information gaps can be narrowed by (1) rigorous and ongoing monitoring of markets especially by central banks; and (2) close and informal communication between monetary authorities and the leaders of key financial institutions, and (3) ongoing communication and coordination between supervisory authorities, central banks and relevant governmental bodies.

  9.  Faced with the reality of a financial crisis with potential systemic characteristics, the most difficult judgments that authorities must confront are: (1) the likely speed and reach of contagion; and (2) whether the contagion factor is primarily being driven by market illiquidity considerations as distinct from concerns about institutional solvency.

    (9a)  While the liquidity/solvency distinction is never clear cut, I believe it is fair to say that in the financial crises of 1987, 1998, and the current situation, central bank interventions were motivated primarily by market liquidity considerations or the need to provide the markets with large amounts of temporary liquidity primarily through the use of open market operations.

    —  The use of open market operations provides the advantages that (1) such liquidity support can be reversed with relative ease when the crisis eases; and (2) the marketplace—not the authorities—make the business and credit decisions as to how that liquidity will be allocated among competing uses.

    (9b)  Even when intervention is framed around contagion and market liquidity considerations, the moral hazard dilemma does not disappear although the horns of that dilemma are somewhat muted.

  10.  On the other hand, the moral hazard problem is considerably more acute if the issue at hand involves a judgment about intervention growing out of an actual or potential insolvency question involving one or more institutions. In such circumstances, monetary authorities will almost always have to make the very difficult judgment of whether the disorderly failure of such an institution will trigger dangerous contagion effects on other institutions or on financial markets and/or the economy generally.

  11.  In these circumstances, decisions to intervene—and the nature of such intervention—must always be made on a case-by-case basis against the backdrop of what, for years, I have called a policy of "constructive ambiguity". In other words, since it is impossible to anticipate every low probability contingency that may arise, authorities must preserve the flexibility to respond as the circumstances of a given situation require.

  12.  While the presence of a system of deposit insurance helps to produce a strong tilt against intervention, extreme situations can still arise in which authorities may conclude that circumstances warrant extending protection to depositors (and even other creditors) beyond the limits of deposit insurance. We are all familiar with episodes in major industrial countries—including the 1980's thrift institutions crisis in the U.S.—in which authorities concluded that such extraordinary intervention was necessary in the face of the threat of a broad-based financial melt-down that could threaten the real economy.

  13.  To summarize, the moral hazard problem is very real. By the same token, and even as we continue to strengthen the shock absorbers of the financial system, we know that infrequent financial shocks will occur in the future in which official intervention may be necessary and appropriate even if there should always be a strong bias against such intervention.

4 December 2007

previous page contents next page

House of Commons home page Parliament home page House of Lords home page search page enquiries index

© Parliamentary copyright 2008
Prepared 1 February 2008