Financial policymakers have a tough job. They set monetary policy and must maintain the soundness and stability of the financial system. When crises such as the 1987 stock market crash or the 1998 Russian debt default occur, policymakers work to prevent them from wreaking harm on the financial system as a whole — and they strive to limit the damage that results.

In addition, bank regulators and financial policymakers can find themselves caught in a bind: They are frequently called upon to make decisions in times of uncertainty. During a crisis, when reliable information about the markets is scarce and people are panicked, they must act with Solomonic wisdom. They can’t be too interventionist or too hands-off, too trigger-happy or too delayed, too confident in their actions or too meek.

A recent Wharton conference, co-sponsored by Mercer Oliver Wyman Institute, the Alfred P. Sloan Foundation and Wharton’s Financial Institutions Center, explored this topic for an audience of academics and financial industry executives. “Financial Risk Management in Practice: The Known, the Unknown and the Unknowable” looked at how these various categories of risk are described and understood in areas ranging from financial policymaking and banking to insurance and asset management.

The panel on policymaking included three well-known banking regulators. Andrew Crockett is president of JPMorgan Chase International and a former general manager of the Bank for International Settlements, an international organization of central banks. Prior to that, he was an executive director of the Bank of England. Anthony Santomero is president of the Federal Reserve Bank of Philadelphia and professor emeritus of finance at Wharton. Donald Kohn is a member of the Board of Governors of the Federal Reserve System.

Over the last several decades, financial institutions have made big strides in monitoring and managing the market and credit risks to which they are exposed, noted Crockett. “Theoretical and technical developments have added to the efficiency with which risks can be quantified, priced and traded, and that has therefore strengthened overall resource allocation and improved financial sector resilience.”

He laid out definitions of known, unknown and unknowable risks. He described known risks as “regularities estimated from historical relationships.” What is unknown is what will happen at any particular point in time or on any particular occasion. “We may know that average default probabilities will change by X [in the event of a given percentage point change in interest rates], but not which loans will be affected,” he explained, referring generally to a bank’s loan portfolio.

In this context, what is unknowable is “how the regularity may be affected by unpredictable events or how it may change over time,” Crockett said. An example of an unknowable event is a terrorist attack or a large-scale natural disaster like the Northridge earthquake of 1994 or the Indonesian earthquake and tsunami that occurred in December.

What makes unknowable events or crises so difficult to handle, from the perspective of a policymaker, is the chaos that overtakes the normal functioning of markets. Information about prices is hard to come by, uncertainty prevails, and traditional measures of risk can’t be trusted. In financial terms, statistical relationships that were relatively consistent in normal times can be thrown out of whack, triggering huge losses and liquidity concerns. When Russia defaulted on its debt in August 1998, for instance, the spread between the yields on various debt instruments widened well beyond historically observed ranges. Within weeks these market dislocations brought Connecticut-based Long Term Capital Management, a large hedge fund with a complex “relative-value” playbook, to the brink of collapse. It controlled derivatives positions with a notional value of $1.25 trillion, and to stave off a financial disaster, the New York Federal Reserve mediated a bailout by the hedge fund’s largest creditors.

Since predicting the scope and content of future crises isn’t possible, regulators learn from the past and encourage and reward the use of sophisticated risk management techniques and stress tests at banks. Risk management in general tries to shift risks that are considered unknown into the category of known risks and tries to mitigate the costs associated with things that remain unknown, Crockett noted. Events that can’t reliably be moved into the known category are dealt with differently. Insurance, the securitization of assets, and derivatives contracts are ways that institutions can transfer risks they don’t want to hold on their books to those willing and able to accept those risks for a price.

Asymmetry of Information

Santomero talked about the structure of regulation. While risk management at financial institutions has become stronger over the years, and more sophisticated techniques exist to identify and manage risks, one difficulty regulators have traditionally faced is an asymmetry of information. For instance, when a regulator looks at a bank’s loan portfolio, the bank has a better idea of the risks to which it is exposed than does the regulator. “This creates a tension,” he said.

In recent years, regulators have adapted in order to improve regulatory efficiency. For nearly two decades, according to Santomero, banks have been required to set aside capital against the market and credit risks they faced according to a relatively simple model devised by the Basel Committee, a group within the Bank for International Settlements that formulates capital adequacy guidelines for international banks. Recently, the Basel Committee revised the way minimal capital levels are determined. According to the new Basel II framework, some of the largest banks will be able to use their own internal ratings-based models to assess the riskiness of various bonds and credit instruments, in lieu of the blunt-force instrument they have thus far used to determine regulatory capital requirements.

Where regulators once preferred a rudimentary model because it was standardized, they are now about to allow financial institutions to use their own proprietary models. This is a step forward, said Santomero, but “it’s a tricky step to take because it requires a leap of faith of a structural design.”

Santomero stressed that the costs as well as the benefits of shifts in regulatory structure must be weighed. While regulators recognize that the expertise developed by market participants may increase the efficient use of capital, they must proceed cautiously. Banks are not perfect, he said. Regulators face the risk that a model, however robust and however much it has been back-tested, might be based on faulty or outdated assumptions. The regulator also faces the risk that it could be misled by the bank, either deliberately or by mistake.

There needs to be a “mechanism whereby the regulator has the ability to feel comfortable that what he’s learning from the regulated is consistent with what he needs to know,” said Santomero. This means that regulators need to validate the internal structure of credit risk models. They must also ensure that there is “incentive compatibility” — that the bank is negotiating with the regulator in good faith and is actively using the model and not just whipping it out to get a regulatory capital benefit, he added.

Santomero and Crockett both noted that excessive regulation around risks that can’t be quantified in any way could be counterproductive. After all, regulation cannot deal with all contingencies. “If there’s more regulation around things we can’t characterize, that leads to inefficiencies and could also lead to circumvention of the underlying regulation,” said Santomero. Crockett added that burdensome restrictions on banks could have “unintended negative impacts on the health of financial markets, causing business to move to riskier, less well-regulated non-bank intermediaries.”

In the case of a serious financial crisis, financial policymakers should not kid themselves that they can hit on the one perfect remedy — even if such a solution existed. Moreover, micromanaging a particular outcome when the markets are stressed and individuals are acting on limited information is next to impossible. Consequently, in thinking about what is in fact unknowable, financial policymakers should place a “higher value on avoiding bad outcomes than on securing the optimum,” Crockett said. Policymakers should supervise conservatively, and banks should be capitalized sufficiently to avoid capsizing under extreme stress. Crockett noted that the main question a policymaker should ask is, “Is the system resilient to a range of bad outcomes?”

Moral Hazard

The Federal Reserve’s Kohn focused his comments on how policymakers function during times of great duress. “The very nature of a crisis means the ratio of the unknown and unknowable is high relative to the known,” he said. That influences the way policymakers evaluate the costs and benefits of various courses of action.

He agreed with Crockett that regulators should try to reduce the likelihood of crises and systemic risk, since managing crises has become harder in an environment of global and increasingly complex financial institutions. During crises, he said, the central bank must incorporate into its decisions the risks and uncertainties of several alternative outcomes — not only the likely outcome, but the probability of the unusual, or extreme, event occurring.

Financial policymakers must also walk a fine line between action and inaction. “In a crisis, the potential cost of inaction or inadequate action is a disruption to the economy, which would dampen activity and put undesirable downward pressure on prices,” Kohn said. Panicked lenders could radically pare back credit supplies. Widespread concern about counterparty risk — the risk that the institution on the other side of a financial contract won’t meet its obligations — could hurt the functioning of payment and settlement systems, the backbone of the financial system and one of the ways that a shock in an isolated area can spread through the industry. Confidence in the markets could easily be dragged down, depressing economic activity and productivity.

On the other hand, the actions of financial policymakers could boomerang on them. Their responses during a crisis could cause “moral hazard” problems. This refers to the fact that a person or entity that expects another party to shield them from negative consequences may take on greater risks. For example, if the Federal Reserve “makes credit available to individual firms at terms that are more favorable than those available in the market, or gives protection to banks extending credit during a crisis,” those financial institutions may have an incentive to not reduce their risks in the first place, said Kohn. The moral hazard produced by a regulator’s actions can thus strangle its ability to get the results it desires, either during the crisis at hand or when the next disaster occurs.

Kohn added that the degree of moral hazard depends on the instrument chosen by the policymaker. Generalized approaches such as open market operations that work through the entire market, rather than individual firms, have a lower probability of distorting risk-taking. Open market operations refer to the Federal Reserve’s ability to buy or sell Treasury securities to control the supply of money in the system — and thus to affect short-term interest rates. Other instruments to deal with financial instability include discount window lending, “moral suasion” (a higher form of persuasion), and Federal Reserve actions to keep financial institutions up and running. However, Kohn said, these options are “more likely than monetary policy adjustments to have undesirable and distortionary effects.”

In the event of a crisis, there are two fundamental actions a policymaker or central bank should take, according to Kohn. First, it should make absolutely sure that there is adequate liquidity in the financial system, and second, it should determine whether monetary policy needs to be adjusted to counter the effects of tighter credit on the economy.

That said, he highlighted some of the questions policymakers and regulators should ask themselves during a crisis: “How large is the disruption? How many firms or market participants are involved? How large are those firms? What is the potential for direct and indirect contagion — domestic and international? Who are the counterparties? What is their exposure? Who else has similar exposures and might be vulnerable to further changes in asset prices? How long are financial disruptions likely to last? Are substitute providers of financial services available? How easily and quickly can they be employed? And, critically, what are the initial and expected states of the macroeconomic and financial environments under these various scenarios?”

The regulators on the panel agreed that during a crisis a tremendous amount of information is required — precisely when that information is difficult to acquire and analyze judiciously. Policymakers must be able to communicate and cooperate with other agencies and regulators, both domestic and foreign, when the need arises. They must also be aware that contagion and interdependencies among key market participants can develop in previously unknown and unprecedented ways. “History may be the best guide to the future, but it isn’t the future,” Crockett said.

Kohn added a final note of stern caution. The financial system has clearly proven to be robust in recent difficult times, and no large financial institution has gone bust and caused a systemic risk. In his view, however, that shouldn’t prevent tough decisions from being made in the future. “No institution can be too big to fail,” he said. “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 be complicated. But we can’t allow the public interest in containing moral hazard to be held hostage to complexity.”