Currently, the Federal Reserve relies on a patchwork of authorities, largely derived from our role as a banking supervisor, as well as on moral suasion to help ensure that critical payment and settlement systems have the necessary procedures and controls in place to manage their risks.  By contrast, many major central banks around the world have an explicit statutory basis for their oversight of these systems.  Given how important robust payment and settlement systems are to financial stability, and the functional similarities between many payment and settlement systems, a good case can be made for granting the Federal Reserve explicit oversight authority for systemically important payment and settlement systems.  

Banks with the lowest supervisory ratings have reduced their lending significantly more than have banks in better health.  Empirical research suggests that during previous banking crises this behavior was, to an important degree, explained by differences in the ability to supply credit not just differences in the demand for credit. [Footnote 5] Thus the evidence from Japan and previous problems in the U.S. indicates that allowing poorly capitalized banks to continue operations with insufficient capital is likely to exacerbate problems with credit availability.

The challenge for regulators and other authorities is to create an environment that supports greater bank intermediation, which should help to restore the health of the financial system and the economy. We want banks to be willing to deploy capital and liquidity, but they must do so in a responsible way that avoids past mistakes and does not create new ones.

...

The events of the past year and a half have highlighted the need for changes in our financial system. Presumably, such changes may include a different balance between bank-based and market-based financial intermediation. As regulators of banks and thrifts, our job is not to determine what this balance should be. Rather, our job is, and has been, to create an environment in which, in the short run, banks can step up to fill as much of the gap as possible that has been left by still-dysfunctional markets, consistent with a strong, stable banking system. Over time, of course, we will need to work with the Congress and the new Administration to construct a system of oversight over both markets and institutions that better protects the stability of the financial system and the U.S. economy.

Financial crisis can serve as a powerful stimulant to the evolution of market mechanisms, and I expect that the aftermath of the present turmoil will see both innovation and incremental refinement to quality assurance in credit markets and in counterparty credit risk management.  I would like to highlight two themes that I believe will influence this process.

First, for quality assurance to be effective, some of the products traded in financial markets have to become simpler and more transparent.

...

A second key factor for effective quality assurance relates to the institutional and contractual framework for ensuring future performance on financial transactions, namely counterparty credit risk management.  Counterparty credit risk management should be focused on its effectiveness in different market situations and its implications for financial stability.

...

(I)t is not just the banking industry, but also those of us in the public sector who have some key lessons to learn.  Banks and supervisors alike need to undertake additional work to facilitate the building of robust methods of quality assurance in the financial markets that will help to restore and maintain confidence.  Ensuring that banks exercise good risk management, of course, is an important job for bank supervisors, which includes overseeing their ability to properly capture the risks in the markets in which they operate, as well as their ability to conduct appropriate stress testing to explore potential consequences of different types of market distress.  Doing so requires that supervisors themselves develop a strong understanding of the value, limits, and potential harms associated with banks' attempts to protect their exposures.

This expansion of the scope and scale of Fed lending may not have been so large had we had better resolution mechanisms to deal with such failing firms as Bear Stearns and AIG. And perhaps our lending would not have become so wide-ranging had there been better regulation or more resiliency in the payment and settlement systems, including more transparency about the markets for mortgage-backed securities and credit default swaps.
...

Some may think access to the Fed's lending facilities should be permanently expanded to include a wide range of financial institutions. I believe such expanded access to central bank credit would raise significant issues of moral hazard that would need to be addressed. And I have urged that we must continue to avoid compromising the Fed's independence — one of the great strengths of central banks.

Some people might think that expanding the Federal Reserve's regulatory and supervisory authority and giving it a sweeping mandate for financial stability would prevent the types of financial crises we have been experiencing this year. That is unrealistic.

...

Going forward our focus should be on better regulation, not necessarily more regulation. We need to focus on ways to strengthen our financial markets to make market discipline more effective at mitigating systemic risk. We should think about which financial markets are critical to the efficient functioning of the payment system rather than focusing on individual firms. Ideally, we need to determine which aspects of the financial system are critical and then make sure we have the market mechanisms, regulations, and supervision to ensure those sectors are resilient.

(T)he ongoing fundamental transformation in financial services offers great potential opportunities for those institutions able to integrate strategy and risk management successfully, and I will argue that survival will hinge upon such an integration in what I will call a "strategic risk management framework."

...

Over the past year there have been a number of studies analyzing the causes of the current turmoil, which include shortcomings in the risk management practices of financial institutions.² It is absolutely clear that many financial institutions need to undertake a fundamental review of risk management. They now realize that ignoring risk management in any aspect of the banking business usually creates problems later on. Risk management shortcomings need to be addressed not only to improve the health and viability of individual institutions, but also to maintain stability for the financial system as a whole.

Over the past year, there have been a number of suggestions for possible statutory changes in U.S. financial services regulation, so bank directors must be prepared for whichever outcomes such changes might imply for the regulatory structure in the United States. For example, the Congress may wish to undertake legislative action to effect regulatory changes, or there may be changes to the existing authority and responsibility of certain regulatory bodies. In any event, there will likely be some type of adjustments in regulatory structure simply given the changes in the financial services landscape. Given the fluid situation in which we find ourselves today, bank directors and senior management in their strategic planning have to anticipate a range of potential outcomes in the regulatory sphere in both the short and long term.

I think we're in for an episode where the rate of which banks fail is likely to increase. Of course it's been exceptionally low in the last few years, so it shouldn't, I don't think it should concern us.

We have long had a list of specific reforms to address TBTF, but we have not prioritized those proposals. So of the many recommendations we made, where would we have policymakers start? We would begin the effort to manage TBTF with an approach we call systemic focused supervision (SFS).

I earlier described SFS in general as an effort to apply a focus on spillover reduction to supervision, regulation, and communication as well, but let me now detail its three pillars: they are stress testing; enhanced prompt corrective action (PCA); and stability-related communication.

Cooperation between the Fed and the SEC is taking place within the existing statutory framework with the objective of addressing the near-term situation. In the longer term, however, legislation may be needed to provide a more robust framework for the prudential supervision of investment banks and other large securities dealers. In particular, under current arrangements, the SEC's oversight of the holding companies of the major investment banks is based on a voluntary agreement between the SEC and those firms. Strong holding company oversight is essential, and thus, in my view, the Congress should consider requiring consolidated supervision of those firms and providing the regulator the authority to set standards for capital, liquidity holdings, and risk management.⁶ At the same time, reforms in the oversight of these firms must recognize the distinctive features of investment banking and take care neither to unduly inhibit innovation nor to induce a migration of risk-taking activities to less-regulated or offshore institutions.

Concerns in financial markets about the creditworthiness of some financial intermediaries have eased somewhat since the first half of March, but those concerns remain relatively high. More fundamentally, the proper management of counterparty credit risk--which is the risk of loss from a counterparty's failure to perform its financial obligations--is a prerequisite for protecting the entire system from contagion when any one institution fails.

Consistent with the recommendations of recent reports, we are looking at how firms are addressing weaknesses in counterparty credit risk management practices highlighted by recent events, including the measurement and aggregation of exposures stemming from a wide range of transactions with both unregulated and regulated entities...In this context, we have been closely monitoring counterparty exposures arising from transactions with monoline financial guarantors and have been discussing with banks the measurement and management of these positions.

Finally, it is worth noting that the Federal Reserve's umbrella supervision role closely complements our other central bank responsibilities, including the objectives of fostering financial stability and deterring or managing financial crises. The information, expertise, and powers derived from our supervisory authority enhances the Federal Reserve's ability to help prevent financial crises, and to manage such crises should they occur, working with the Treasury Department and other U.S. and foreign authorities. In this manner, enhancements to our consolidated supervision program, which include close coordination with primary supervisors and functional regulators, should provide broad benefits for the financial system and the economy.

I believe the severity and complexity of this crisis makes a compelling case for a comprehensive reassessment of how to use regulation to strike an appropriate balance between efficiency and stability. This is exceptionally complicated, both in terms of the trade-offs involved and in building the necessary consensus in the United States and the world. It is going to require significant changes to the way we regulate and supervise financial institutions, changes that go well beyond adjustments to some of the specific capital charges in the existing capital requirement regime for banks.

The major central banks should put in place a standing network of currency swaps, collateral policies and account arrangements that would make it easier to mobilize liquidity across borders quickly in crisis. We have some of the elements of this framework in place today, and these arrangements have worked relatively well in the present crises. We should leave them in place, refine them further and test them frequently.

Our goal is to emerge from this difficult period with a financial system that will be more stable without being less innovative, with a more effective balance between market discipline and regulation.