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For release on delivery
1:00 p.m. EST
February 21, 2007

Financial Stability: Preventing and Managing Crises
Remarks by
Donald L. Kohn
Vice Chairman
Board of Governors of the Federal Reserve System
at the
Exchequer Club Luncheon
Washington, D.C.
February 21, 2007

Thank you for the opportunity to speak here today. The Exchequer Club has
enriched policy development in Washington for nearly a half century by providing a
forum for the discussion of important national economic and financial policy issues. I am
honored to participate in that discussion.
I want to talk this afternoon about some aspects of financial stability, a topic that
has received increased attention in recent years from central banks and regulators as well
as the financial media. 1 A number of developments have contributed to this trend. Just a
few years ago, the terrible events of 9/11 alerted us to the importance of operational
resiliency in a dangerous world. But other forces have also led central banks and other
financial supervisors around the world to increase their emphasis on financial stability.
Perhaps most important, the financial system, once essentially bank-centered, has become
more market-centered. Of course, banks continue to be core participants in the financial
system and to provide an indispensable window on market activities. But the
development of a relatively market-oriented system has been accompanied by a large
number of new participants, many with global reach, and a much larger array of financial
instruments. This vastly expanded web of participants and instruments has increased the
number of potential channels for the creation and transmission of financial shocks. And,
some of the new financial instruments and markets have not been tested under extended
stressful conditions. In addition, supervisory authority in a number of countries abroad
has been consolidated and separated from central banks; these moves have forced the
new regulators and their central bank colleagues to learn how to operate not only in a new
financial landscape but also in a new regulatory environment.

1

Scott Alvarez and Myron Kwast, of the Board’s staff, contributed to these remarks, which represent my
own views and not necessarily those of other members of the Board or its staff.

-2Finally, in today’s global economy, very settled financial market conditions-narrow risk spreads and low expected market volatility--coexist with unprecedented
current account imbalances among nations and interest rates that are low by historical
standards. In such a world, it would be imprudent to rule out sharp movements in asset
prices and a deterioration in market liquidity that would test the resiliency of market
infrastructure and financial institutions.
While these factors have stimulated interest in both crisis deterrence and crisis
management, the development of financial markets has also increased the resiliency of
the financial system. Indeed, U.S. financial markets have proved to be notably robust
during some significant recent shocks, such as the sharp decline in equity prices
beginning in 2000 and the failure of some large firms, including Enron and Amaranth.
New computing and telecommunications technologies, along with the removal of legal
and regulatory barriers to entry have heightened competition among a wider variety of
institutions and made the allocation of funds from savers to investors more efficient.
Technology also has helped financial market participants better understand the risks
embedded in assets and develop instruments and systems for managing those risks, both
individually and on a portfolio basis. Together, these developments have allowed
suppliers and demanders of funds and the intermediaries that stand between them to
diversify their risk exposures, reduce their vulnerability to sector- or region-specific
shocks, and become far less dependent on specific service providers. In short, market
developments that have altered the character and transmission of financial shocks have at
the same time spread risks more widely among a greater number and broader range of
market participants and given them the tools to better manage those risks.

-3The Federal Reserve, in its roles as a central bank, a bank supervisor, and a
participant in the payments system, has been working in various ways and with other
supervisors to deter financial crises. As the central bank, we strive to foster economic
stability. As a bank supervisor, we are working with others to improve risk management
and market discipline. And in the payments and settlement area, we have been active in
managing our risk and encouraging others to manage theirs.
In every step we take to deter or manage financial crises, it is important that we
recognize that we impose costs, and that our efforts can be most effective if we both
enhance and are supported by market discipline. Institutions and investors must be
allowed to take risks and must be prepared to accept the consequences of their actions.
For its part, the government should limit its intervention to those circumstances that could
lead to placing the system in serious danger and could spill over to the economy.
Otherwise, even the most well-intentioned government intervention can actually weaken
the system by undermining the incentives for market participants to limit the risks they
undertake.
Deterring a Financial Crisis
The first line of defense against financial crises is to try to prevent them. A
number of our current efforts to encourage sound risk-taking practices and to enhance
market discipline are a continuation of the response to the banking and thrift institution
crises of the 1980s and early 1990s. In 1989, more than 500 banks and thrifts failed, and
it was not until 1993 that the annual number of bank failures dropped well below 100.
One of the most important reforms produced in reaction to this crisis was a tightened
focus on bank capital. This tightening began with Basel I, the international capital accord

-4of 1988, which emphasized the importance of connecting bank capital and bank
supervision to bank risk. Supervisory efforts today to develop a more advanced set of
international capital standards, in Basel II, are in large part aimed at strongly reinforcing
that connection.
Identifying risk and encouraging management responses are also at the heart of
our efforts to encourage enterprisewide risk-management practices at financial firms.
Essential to those practices is the stress testing of portfolios for extreme, or “tail,” events.
Stress testing per se is not new, but it has become much more important. The evolution
of financial markets and instruments and the increased importance of market liquidity for
managing risks have made risk managers in both the public and private sectors acutely
aware of the need to ensure that financial firms’ risk-measurement and management
systems are taking sufficient account of stresses that might not have been threatening ten
or twenty years ago.
A second core reform that emerged from past crises was the need to limit the
moral hazard of the safety net extended to insured depository institutions--a safety net
that is required to help maintain financial stability. Moral hazard refers to the heightened
incentive to take risk that can be created by an insurance system. Private insurance
companies attempt to control moral hazard by, for example, charging risk-based
premiums and imposing deductibles. In the public sector, things are often more
complicated. However, the Federal Deposit Insurance Corporation Improvement Act of
1991, or FDICIA, took major steps toward reducing moral hazard in the banking system
and limiting taxpayer losses by reinforcing the importance of strong capital. Among the
mechanisms in the act is the requirement that bank supervisors take prompt corrective

-5action when depositories show signs of becoming troubled. This step was reinforced by
the least-cost requirements of FDICIA, which generally require the FDIC to resolve a
failing institution in the manner least costly to the deposit insurance fund. Importantly,
this provision encouraged market discipline by putting uninsured depositors and other
uninsured creditors at greater risk.
FDICIA allowed for the relaxation of its least-cost mandate in situations posing a
true systemic crisis. But the conditions under which least-cost resolution can be relaxed
are quite strict. First, a least-cost resolution would have to create “serious adverse effects
on economic conditions or financial stability.” Second, any action under the exception
must be recommended by at least two-thirds majorities of the boards of both the FDIC
and the Federal Reserve and ultimately approved by the Secretary of the Treasury in
consultation with the President.
The systemic-risk exception has never been invoked, and efforts are currently
underway to lower the chances that it ever will be. For example, last December, the
FDIC published an important proposal to improve its ability to resolve a troubled large
depository institution in a least-cost manner.2 The FDIC proposal seeks to ensure that the
largest banks and the FDIC have in place data and other management systems that would
aid the FDIC in quickly identifying insured deposits and allow the FDIC to regulate the
outflow of uninsured deposits while that identification was being completed. This
proposal would, among other things, allow the FDIC to continue to protect insured
depositors while making clear to uninsured depositors that they could suffer losses in the

2

Federal Deposit Insurance Corporation (2006), “FDIC Solicits Comments on Improvements to
Determining Insured Deposits at Large Banks,” press release 111-2006, December 5,
www.fdic.gov/news/news/press/2006/index.html.

-6event of the failure of even a very large bank. Thus, these changes would greatly
enhance market discipline and help ensure that no bank is too big to fail.
Crisis prevention has also been a focus of attention in the payments area. At the
Federal Reserve, we have improved the technological redundancy and security of our
payments system and have encouraged other participants to do the same. We have also
sought ways to make the clearing and settlement infrastructure keep pace with the rapid
growth and evolution of financial markets and instruments. The over-the-counter (OTC)
derivatives markets provide a good example. Those markets, especially the newer
markets for credit derivatives, have been growing very rapidly. Until 2005, however, the
confirmation of trades remained largely decentralized and manual. The result was a huge
backlog of unconfirmed trades, which, to the extent it resulted in inaccurate trade records,
had the potential to exacerbate market participants’ market and credit risks.
The Federal Reserve Bank of New York has taken the lead, working with other
domestic and international supervisors, in helping the OTC derivatives market develop a
stronger clearing and settlement infrastructure. Those efforts focused initially on credit
derivatives. At the urging of supervisors, market participants set goals and implemented
policies for reducing the huge backlogs of unconfirmed trades. As a result, confirmation
backlogs were reduced 94 percent between September 2005 and November 2006.
Market participants also promptly ended the practice of assigning trades without the prior
consent of the counterparty and developed cash settlement as an alternative to physical
settlement of credit derivatives in the event of a default of a participant that is a reference
obligor. Moreover, market participants have now agreed to turn their attention to equity
derivatives, for which large backlogs still exist. They are also providing supervisors with

-7data on backlogs of all types of OTC derivatives, which will allow the supervisors to
monitor the industry’s progress across the board.
Managing a Financial Crisis
Clearly, when it comes to a financial crisis, as with so many other potential risks,
an ounce of prevention is worth many pounds of cure. But experience tells us that,
despite our best efforts at deterrence, true financial crises will occur from time to time.
Prudently managing these tail events is no easy task. A large part of the difficulty arises
from the fact that some policy responses may have important costs that need to be
balanced against their possible benefits in reducing or ameliorating the adverse effects of
a crisis. In particular, intervening in the market process can increase moral hazard by
weakening market discipline if private parties come to believe that policy actions will
relieve them of some of the costs of their own poor decisions or even just bad luck. And
weaker market discipline cannot only distort current resource allocation but also sow the
seeds of a future crisis.
If, nonetheless, policymakers reach a judgment that action must be taken, the
central bank and other authorities have a variety of instruments to use. The degree of
potential moral hazard created will depend on the instrument chosen. Policy actions that
work through the overall market rather than through individual firms create a lower
probability of distorting risk taking. Thus, a first resort in managing a crisis 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 such demands are not satisfied, financial markets will tighten at
exactly the wrong moment. This was, for example, an important consideration after the

-8stock market crash of 1987, when demand for liquid deposits raised the demand for
reserves held at the Fed; and again after 9/11, when the loss of life and destruction of
infrastructure impeded the flow of credit and liquidity.
Second, we must determine whether the stance of monetary policy should be
adjusted to counteract the effects on the economy of tighter credit supplies and other
knock-on effects of financial instability. As a result, 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 discuss the appropriate policy response.
Other policy instruments that can be used to deal with financial instability-discount window lending, moral suasion aimed at convincing private parties to keep
credit flowing, actions to keep open or slowly wind down troubled institutions--are, in
my judgment, more likely than open market operations or monetary policy adjustments to
have undesirable and distortionary effects. Hence, they should be, and are, used only
after a finding that broader instruments, like open market operations, are unlikely to
prevent significant economic disruption. And in my view, when relatively targeted
policy interventions are employed, their use should be designed to minimize moral
hazard. For example, if the central bank concludes that it must lend to individual
depository institutions, any such loans should, in most situations, be on terms sufficiently
onerous to encourage a quick return to market funding.
The central bank will and must be involved in the management and resolution of
financial crises. Indeed, a major reason for the founding of the Federal Reserve in 1913

-9was the need to address periodic banking crises and financial panics, which had plagued
the U.S. economy during the nineteenth and early twentieth centuries. And the need
remains today for Federal Reserve involvement in crisis management and resolution.
The Federal Reserve’s ability to conduct open market operations, make discount window
loans, and provide funds intraday to key payments system participants are unique tools
necessary to ensure that the financial system stays liquid. Our monetary policy
experience and responsibilities afford us valuable insights into how financial disruptions
may be affecting the real economy. Our dual role as both a payments system participant
and a payments system supervisor helps us manage problems that arise in this key
segment of the financial system. Finally, for a variety of reasons, the Federal Reserve has
developed extensive relationships with foreign central banks and bank supervisors.
These relationships have proved useful in past crises and will likely be even more
valuable in an increasingly global financial and economic system.
When managing a crisis, prudent decisionmaking depends on the best possible
information acquired in the shortest possible period of time. By information I mean more
than just facts; I mean the informed analyses of the facts that help us understand the true
financial condition of the distressed firms and markets and the potential for broader
effects. For example, if a major financial institution is facing serious problems, we need
to know its most important on- and off-balance-sheet activities, its key lines of business,
its most important counterparties, its most important market activities, and its net worth
as well as how close it is to failure. In addition, we must get a fix on the primary causes
of the institution’s problems and on how long the causal factors are likely to last.

- 10 Once we understand as best we can the situation we face, we need information to
help us assess whether the financial disruption has the potential to significantly spill over
to the real economy. The extent of spillover depends upon complex patterns of
interdependencies between the immediate source of the financial disruption and other
parties, and the speed and cost with which affected parties could obtain substitute
providers for the financial services that have been disrupted. As you can imagine, getting
the needed information is likewise a very complex and uncertain task, especially when
timeliness is of the essence. Once such questions are answered, we would have to judge
the possible effects of the financial shock on credit flows, payments and settlement
systems, and asset prices and, more broadly, on uncertainty and confidence in the
financial sector. We would then go on to consider how these effects might influence
consumption, investment, and employment.
Although information when financial stability may be threatened is crucial, the
regular and periodic collection of information in more normal times has limitations and
potential costs, especially for sectors that do not have access to the public safety net. For
example, if it leads market participants to believe that the government will in some
circumstances protect them from loss, the costs of the resulting increase in moral hazard
and reduction in market discipline could exceed the benefits the information would
provide to policymakers. And such information may be of little value to policymakers in
a crisis if private risk managers can change their positions so rapidly that any periodic
information collection by supervisors about risk positions would be out-of-date.
The Federal Reserve’s activities as a bank supervisor provide us with important
and sometimes critical information, expertise, credibility, and powers to both deter and

- 11 manage financial crises. Thus, I want to take this opportunity to emphasize and reinforce
the case for central bank involvement in bank supervision made by Chairman Bernanke
in a speech last month. The deterrence and management of financial crises are of vital
practical concern. The uncertainties surrounding these tasks are greater than anyone
would want, and the costs of failure are much greater than anyone could desire. In my
experience, the information, expertise, credibility, and powers that the Federal Reserve
derives from its supervisory activities are extraordinarily helpful in our efforts to
maintain economic and financial stability. Perhaps we could be successful, as central
banks in a number of countries are trying to be, without supervisory authority. But I, for
one, would not want to take that risk.
Conclusion
Financial stability was the first and perhaps the most important responsibility of
the Federal Reserve. To meet that responsibility, we must cooperate closely with
colleagues here and abroad to adapt our techniques for preventing and managing
situations that could undermine financial and economic stability. As I have tried to
emphasize today, that process of adaptation must also recognize that it is ultimately the
decisions of private participants, not governments, on which we rely for financial
stability. As we interact with the private sector, we must preserve the incentives for
innovation, the rewards for success, and penalties for failure that have made our financial
markets the engines of rising living standards in a dynamic market economy.