Memorandum from E Gerald Corrigan, Goldman
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.
I. SYSTEMIC FINANCIAL
1. Financial shocks are distinguished from
(1a) Financial shocks have the potential
to inflict serious damage on the financial system and/or the real
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
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
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
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 clearat
least with the benefit of hindsightthat 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
(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 degreeif
not kindfrom 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.
II. THE MORAL
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 hazardor
the risk that such interventions will protect institutions and
investors from loss thereby sowing the seeds for even greater
excesses in the futurehave also been a fact of life throughout
(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
(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
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
marketplacenot the authoritiesmake 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
11. In these circumstances, decisions to
interveneand the nature of such interventionmust
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 countriesincluding
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