The Known, the Unknown, and the Unknowable in Financial Risk Management: Measurement and Theory Advancing Practice

By Francis X. Diebold; Neil A. Doherty et al. | Go to book overview

14. Crisis Management
The Known, the Unknown, and the Unknowable

Donald L. Kohn

In pursuing its policy objectives, a central bank must make decisions in the face of uncertainty related to incomplete knowledge about the evolving condition of the economy and the financial system as well as about the potential effects of its actions. This uncertainty implies that the central bank must incorporate into its decisions the risks and consequences of several alternative outcomes. That is, it needs to assess not only the most likely outcome for a particular course of action but also the probability of the unusual—the tail event. And it needs to weigh the welfare costs of the possible occurrence of those tail events.

This risk management approach has been articulated by Chairman Greenspan for monetary policy, and it is equally applicable to a central banks decisions regarding crisis management, the topic I focus on in this chapter.1 Crises are themselves tail events, and the policy response to them is focused on the possibility and cost should the outcome be especially adverse.

Knowledge—reliable information—is essential to managing risks. In a financial crisis, however, information inevitably will be highly imperfect. The very nature of a crisis means that the ratio of the unknown and unknowable will be especially large relative to the known, and this, in turn, can influence how policymakers judge risks, costs, and benefits.

‘Alan Greenspan (2004). Risk and uncertainty in monetary policy. American Economic Review 94 (May), 33–40.

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