In short, creditors probably considered the prospects for Fed assistance {to NBW} to be uncertain. Maybe the Fed would lend; maybe it would not.

Some observers might view this uncertainty positively as 'constructive ambiguity.' In their view, because a troubled bank’s uninsured depositors and other uninsured creditors are not certain Fed assistance will be forthcoming, they have reason to monitor bank risk-taking.

But if these depositors and creditors are unsure about the prospects for Fed lending, the implication is that they see at least some chance of assistance, which would reduce the incentive to monitor risk. This might just as reasonably be called 'destructive ambiguity.' Beyond its impact on uninsured creditor behavior, such ambiguity may expose the Fed to political pressure in problem bank situations, since it implies the lack of a firm and consistent rule on procedure when these situations arise. Indeed, ambiguity may invite creditors who stand to lose money to try to bring political pressure to bear on the Fed.

{Central banks} have all chosen implicitly, if not in a more overt fashion, to set our capital and other reserve standards for banks to guard against outcomes that exclude those once or twice in a century crises that threaten the stability of our domestic and international financial systems.

I do not believe any central bank explicitly makes this calculation. But we have chosen capital standards that by any stretch of the imagination cannot protect against all potential adverse loss outcomes. There is implicit in this exercise the admission that, in certain episodes, problems at commercial banks and other financial institutions, when their risk-management systems prove inadequate, will be handled by central banks. At the same time, society on the whole should require that we set this bar very high. Hundred-year floods come only once every hundred years. Financial institutions should expect to look to the central bank only in extremely rare situations.

I am obviously referring to far more adverse outcomes than I was alluding to in my earlier remarks on the need for private risk-management systems to adjust for crises in their estimates of risk distributions. However, where that dividing line rests is an issue that has not yet been addressed by the international banking community. Clearly, to choose the distribution of risk-bearing between private finance and government is to choose the degree of moral hazard. I believe we recognize and accept it. Indeed, making that choice may be the essence of central banking.

 At a conference honoring Anna Schwartz

Fifth, how much weight should concerns about moral hazard be given when designing mechanisms for governmental regulation of markets? By way of example, we should note that were banks required by the market, or their regulator, to hold 40 percent capital against assets as they did after the Civil War, there would, of course, be far less moral hazard and far fewer instances of fire-sale market disruptions. At the same time, far fewer banks would be profitable, the degree of financial intermediation less, capital would be more costly, and the level of output and standards of living decidely lower. Our current economy, with its wide financial safety net, fiat money, and highly leveraged financial institutions, has been a conscious choice of the American people since the 1930s. We do not have the choice of accepting the benefits of the current system without its costs.

It is the most natural thing in the world to respond to a request for our good offices in a situation like this. But this kind of action does create expectations with respect to what we might do going forward that in turn create expectations about monetary policy.

With any troubled financial institution, but especially in the case of large institutions, I believe discipline will be better served in a context in which the authorities maintain a policy of what I like to call "constructive ambiguity" as to what they will do, how they will do it, and when they will do it.  In saying this, I recognize that financial market particants do not like uncertainty, but that is just the point.  Moreover, while I fully understand the yearning in some quarters for the cookbook approach to problems in financial markets or institutions--large institutions especially--I regret to say that in my judgment such a cookbook does not and never will exist.