My own view is that we should consider hard-wiring more sprinkler systems into financial markets and insitutions. One obvious area to look is whether we can improve the risk-based capital approach embodied in Basel II. If capital is to function effectively, it needs to rise as risks increase and be depleted as losses materialize. I think we need to look especially at the procyclical behavior of leverage that we have observed in some large financial institutions, In addition, I believe there may be merit in considering formal liquidity requirements, and perhaps loan-to-value ratios for banks and other financial institutions, especially the large institutions that provide liquidity and risk-management products to other financial institutions and financial markets. I also think that it is time we extinguish some of the off-balance sheet fictions that have developed to excess in recent years.

The proliferation of credit risk transfer instruments was driven in part by an assumption of frictionless, uninterrupted liquidity. This left credit and funding markets more vulnerable when liquidity receded. Banks and other financial institutions lent substantial amounts of money on the assumption that they would be able to distribute that risk easily into liquid markets. A sizable fraction of long-term assets—assets with exposure to different forms of credit risk—ended up in vehicles financed with very short-term liabilities and was placed with investors and funds that were also exposed to liquidity risk.

By allowing institutions to finance with the central bank assets they could no longer finance as easily in the market, we have reduced the need for them to take other actions, such as selling other assets into distressed markets, or withdrawing credit lines extended to other financial institutions, that would have amplified pressures in markets. These measures—the Term Auction Facility and swap arrangements—have had some success in mitigating market pressures, in part by providing a form of insurance against future stress. We now have in place a cooperative framework for liquidity provision among the major central banks. And we have considerable flexibility to adjust the dimensions of these liquidity tools. We will keep them in place as long as necessary, and continue to adapt them where we see a compelling case to do so.

First, some financial products were not well designed to withstand liquidity problems. To avoid paying banks fees to provide a liquidity backstop, many financial products of recent vintage included provisions to force liquidation when necessary to insure payment to the holders of the higher-graded securities (or slices of securities). This structure was used, for example, by structured investment vehicles (SIVs)

13. However, due to the recent financial stress, assets of SIVs could not be liquidated at prices felt to be reasonable. Broadly speaking, products should be structured to better weather periods of illiquidity, and ratings models should take better account of liquidity risk.

Securities that are consistent enough to trade on an exchange are more likely to have market prices that all participants can use.

the difficulties in obtaining market prices are likely to be significantly reduced, as are the consequent uncertainties like those we are currently facing.

During times of systemwide stress, such as the one we are currently experiencing, significant liquidity demands can emanate from both the asset and the liability side of a bank's balance sheet.  For example, we have recently seen how unanticipated draws on liquidity facilities by structured investment vehicles, commercial paper conduits, and others can lead to significant growth in bank assets.  Moreover, some organizations have also encountered difficulty in selling whole loans or securitizing assets as planned.  There were also cases in which reputational concerns have prompted banks or their affiliates to provide liquidity support to a vehicle or to incorporate some of the vehicle's assets onto the bank's balance sheet, even when the bank had no legal obligation to do so.  In a few cases, these unexpected increases in the balance sheet created some pressures on capital ratios, even when capital levels remained unchanged. 

Stress testing and scenario analysis can provide valuable information about the potential risks of complex investment products, but in many cases application of such tools to structured investment vehicles appears to have been inadequate.  For example, some bankers did not necessarily explore scenarios in which these vehicles' credit ratings could be downgraded... Notably, most of these vehicles mirrored the liquidity mismatch that exists at most banks in that they contained longer-term assets funded by shorter-term liabilities, but it is not clear that banks fully considered the potential funding-liquidity problems that these vehicles could face if there were sudden market moves or if perceptions of credit risk changed.  And they may not have fully explored scenarios in which problems with these vehicles could have ramifications for the bank, such as the need to provide liquidity support to the vehicle or to incorporate some of the vehicle's assets onto the bank's balance sheet. 

There probably will be some bank failures. There are, for example, some small, or, in many cases, de novo banks that are heavily invested in real estate in locales where prices have fallen and therefore they would be under some pressure.  So I expect there will be some failures.  Among the largest banks,  the capital ratios remain good. And I don't anticipate any serious problems of that sort among the large, internationally active banks that make up a very substantial part of our banking system.

From the Q&A session

Even in a more favorable economic environment, some time is likely to be required to restore the functioning and liquidity of a number of markets...    In the end, we will have a safer system, but one with more bank intermediation, less leverage, and higher financing costs for many borrowers.

"The worst is just beginning" for sub-prime loan re-sets.

At Treasury-HUD press conference, as reported by Bloomberg News

The changes to the discount window were designed to assure banks of the availability of a backstop source of liquidity. Although banks borrowed only moderate amounts at the discount window, they substantially increased the amount of collateral they placed with Reserve Banks. This and other factors suggest that these changes to the discount window facility, together with the statements and actions of the FOMC, had some positive influence on market conditions.

Although the specifics vary across central banks, the approaches outlined have several important common elements. We each have taken actions to provide more financing at terms longer than overnight. We each have chosen to auction funding against a broader range of collateral, collateral other than government securities, and in our case with a broader set of counterparties. And we have activated swap lines to help the relevant central banks provide liquidity in dollars in their markets.

.....

The Term Auction Facility gives us a tool that lies somewhere between our open market operations and our primary credit program. It provides a mechanism for expanding the range of collateral against which we provide funds to the market—in effect to change the composition of our balance sheet—in ways we cannot do through traditional open market operations.  And it does this in a way that may be more effective in mitigating a broader marketwide liquidity shortage than does the existing discount window facility, in part because of the perceived stigma in recourse to a facility that has come to be regarded as a source of funds for individual institutions facing a temporary, exceptional need for liquidity. Because the quantity of funds to be injected is known in advance, this mechanism poses fewer complications for our ability to reduce volatility in the fed funds rate around the target.

Clearly, recent Fed policy actions have not protected investors in subprime paper. The policy objective is not to prevent losses but to restore normal market processes. The issue is not whether subprime paper will trade at 70 cents on the dollar, or 30 cents, but that the paper in fact can trade at some market price determined by usual market processes. Since August, such paper has traded hardly at all. An active financial market is central to the process of economic growth and it is that growth, not prices in financial markets per se, that the Fed cares about.   

The recent market disruptions have dramatically underscored the importance of gathering and analyzing information about innovative products. When the price-discovery process for a product is disrupted, both investors and sellers need to engage in a period of information gathering, processing, and analysis in order to re-establish a market price. This can be a gradual process and one that results in fundamental changes to the market for the product.   

In sum, as I have indicated, we will be receiving a good deal of relevant information in the coming days. In making its policy decision, the Committee will have to judge whether the outlook for the economy or the balance of risks has shifted materially. In doing so, we will take full account of the implications for the outlook of both the incoming economic data and the ongoing developments in the financial markets.

Economic forecasting is always difficult, but the current stresses in financial markets make the uncertainty surrounding the outlook even greater than usual. We at the Federal Reserve will have to remain exceptionally alert and flexible as we continue to assess how best to promote sustainable economic growth and price stability in the United States.