Although our actions appear to have helped stabilize the situation, financial markets remain under considerable stress. For example, many lenders have been reluctant to provide credit to counterparties, especially leveraged investors, and have increased the amount of collateral they require to back short-term security financing agreements. Credit availability has also been restricted because some large financial institutions, including some large commercial and investment banks, have reported substantial losses and asset write-downs, which reduced their available capital. The capacity and willingness of some large banks and other financial institutions to extend new credit has also been limited by the reduced availability of external funding from the capital markets for originated assets. The resulting unplanned increases in their balance sheets have strained their capital, thus reducing lending capacity. The good news is that several of these firms have been able to raise new capital, and others are in the process of doing so. However, market stresses are likely to continue to weigh on lending activity in the near future.

Credit is threatening to displace liquidity as the primary antagonist. A credit crunch, particularly for small businesses and consumers, poses meaningful downside risks to the real economy. And market participants are struggling to assess the possibility that the narrative turns into a multi-act, macroeconomic drama.

[L]et me explore three of the most trenchant and overlapping plot lines, none of which seem to avail themselves readily to a speedy resolution. First, a striking loss of confidence is affecting financial market functioning. Second, the business models of many large financial institutions are in the process of significant re-examination and repair. Third, the Federal Reserve is exercising its powers to mitigate the effects of financial turmoil on the real economy. This third plot line, however necessary, will not, in and of itself, ensure a more durable return of trust to our financial architecture. In my view, public liquidity is an imperfect substitute for private liquidity. That is, only when the other plot lines advance apace--meaning that significant, private financial actors return to their proper role at center stage--will credit market functioning and support for economic growth be fully restored. And for that to happen, as I am confident it will, we will find that the financial markets and financial firms are outfitted quite differently.

More fundamentally, in my view, funding market disruptions reflect a striking decline in confidence in the financial architecture itself. Perhaps an analogue to banking systems without deposit insurance is appropriate: Depositors withdraw funds if they believe others will act similarly. In short-term credit markets with minimal liquidity support, investors balk if they lose confidence in other investors' willingness to roll maturing paper. Even when liquidity support exists, it may well prove insufficient to address market-wide concerns. ... After all, a loss in confidence can be completely rational: Illiquidity forces issuers to sell assets into distressed markets.

The case for opportunistic capital is improving. Some curative steps by incumbent financial institutions are in the offing. Financial institutions should continue to reassess their sources and uses of funding, their risk-management systems, risk tolerance, and human capital. Generally, they should not hesitate to pare their dividend and share repurchase programs. And, they should raise new capital to strengthen their balance sheets. These actions, in my view, are important signs of strength, and will ensure that financial institutions thrive in the emerging financial architecture replete with new opportunities. These actions will have concomitant benefits on real economic activity.

We have to find a better balance between market discipline and regulation in our financial system, a better balance between efficiency and innovation and reserves and stability.
...
The best defence is to make sure you get the incentives right so that financial institutions hold larger cushions, larger shock absorbers, in good times, against conditions of stress. Hard to do, complicated to figure out how to do it well - but that's the critical objective.

As reported by Reuters

The U.S. banking system remains well capitalized. The quality of capital and capital ratios are still quite good.

From Q&A as reported by Market News International

Here is a simple analogy to help you think about our effort. The Federal Reserve is charged with conducting monetary policy that sustains noninflationary economic growth. We have at our disposal a tool called the federal funds rate, which we set as the base lending rate for the economy. Think of the fed funds rate as a monetary spigot, and the Fed’s goal is keeping the lawn of the economy green and healthy. If we turn the spigot up too forcefully, we will flood and kill the grass with inflation. If we provide too little, the lawn turns brown, starved for money. To get the money from the spigot to the lawn requires a working system of pipes and sprinkler heads. The “shadow banking system,” however, looks like a Rube Goldberg device designed by a hydrologist on acid, with pipes and conduits that lead every which way and not always toward the goal of sustainable economic growth. Moreover, the system of pipes and outlets is clogged with the muck and residue of a prolonged and frenetic period of unrestrained growth and abuse. Until the confusion and the debris are cleared away, financial intermediaries will be reluctant to book new loans or incur additional risk. This retards the impact of additional monetary accommodation.

Thus, even as we have been cutting the fed funds rate—even as we have been opening the monetary spigot—interest rates for private sector borrowers have not fallen correspondingly, and rates for some borrowers have increased. The grass is turning brown.

Despite the adverse developments in recent months, large U.S. banking organizations, in the aggregate and individually, have maintained capital ratios in excess of regulatory requirements, in part because of steps taken by many to replenish equity positions. Indeed, since last fall, large U.S. bank holding companies have raised more than $50 billion in capital. Although the U.S. banking system will continue to face a challenging environment, it remains in sound overall condition, having entered the period of recent financial turmoil with solid capital and strong earnings.

My basic point is that a process of deleveraging, in which many financial intermediaries are simultaneously trying to shrink the size of their balance sheets, has produced a situation in which the quantity of credit available in the overall economy from a wide range of intermediaries has contracted sharply and suddenly—a credit crunch. Moreover, concerns about credit quality and solvency for intermediaries can devolve into liquidity problems, as in an old-fashioned bank run. Firms in the shadow banking sector are particularly vulnerable to this because, like banks, they typically issue short-term, highly liquid debt. The fear that an institution may be unable to meet its obligations to its creditors may trigger a withdrawal of credit—as in a bank run. Of course, the perceived inability of one institution to meet its obligations is likely to cast doubt on the ability of others to meet theirs, triggering chains of distress and systemic risk.

The Federal Reserve was created precisely to stem such systemic risks by acting as a lender of last resort, although not since the Great Depression has the Fed acted to accomplish it by lending directly through its discount window to an entity other than a depository institution. Had the Fed not intervened, however, Bear Stearns would have been unable to meet the demands of the counterparties in its repurchase agreements, and thus intended to file for bankruptcy. Doing so might well have led to widespread fears in the financial markets,

In sum, understanding banks is critical to understanding how financial shocks can be transmitted to the real economy. Unfortunately, understanding how banks are likely to respond to problems requires far more than published financial statements. While U.S. banks report detailed information on their balance sheets and their income statements, these reports do not provide sufficient information to allow central banks to really discern how banks are responding to problems.

I would say that while to date the problem banks have been quite low, there clearly has been some deterioration since the beginning of this year, and should the economy continue to slow down, as many expect, it is likely that we will continue to see some growth in the problem institutions.

From Q&A as reported by Reuters

As financial markets have changed, it's appropriate for us to step back and review whether the regulatory structure we have in place is keeping pace with the changes that are occurring in financial markets.

From audience Q&A, as reported by Market News International and Reuters.

The crisis will leave many casualties. Particularly hard hit will be much of today’s financial risk-valuation system, significant parts of which failed under stress. Those of us who look to the self-interest of lending institutions to protect shareholder equity have to be in a state of shocked disbelief. But I hope that one of the casualties will not be reliance on counterparty surveillance, and more generally financial self-regulation, as the fundamental balance mechanism for global finance.

The problems, at least in the early stages of this crisis, were most pronounced among banks whose regulatory oversight has been elaborate for years. To be sure, the systems of setting bank capital requirements, both economic and regulatory, which have developed over the past two decades will be overhauled substantially in light of recent experience. Indeed, private investors are already demanding larger capital buffers and collateral, and the mavens convened under the auspices of the Bank for International Settlements will surely amend the newly minted Basel II international regulatory accord. Also being questioned, tangentially, are the mathematically elegant economic forecasting models that once again have been unable to anticipate a financial crisis or the onset of recession.

Credit market systems and their degree of leverage and liquidity are rooted in trust in the solvency of counterparties. That trust was badly shaken on August 9 2007 when BNP Paribas revealed large unanticipated losses on US subprime securities. Risk management systems – and the models at their core – were supposed to guard against outsized losses. How did we go so wrong?

The essential problem is that our models – both risk models and econometric models – as complex as they have become, are still too simple to capture the full array of governing variables that drive global economic reality.

Among the practices addressed by our proposal is the use of yield spread premiums (YSPs).⁶ Many consumers use mortgage brokers to guide them through a complex process and shop for the best deal. Unfortunately, consumers may believe that the broker has a responsibility to get them that best deal, which is not necessarily the case. In fact, the design of YSPs may provide the broker a financial incentive to offer a loan with a higher rate. Consumers who do not understand this point may not shop to their best advantage. Therefore, we would prohibit a lender, for both prime and subprime loans, from paying a broker an amount greater than the consumer agrees to in advance. Brokers would also have to disclose their potential conflict of interest. The combination of stricter regulation and better disclosure will not solve all the problems. We do believe, however, that this proposal will give consumers much better information and raise their awareness of brokers' potential conflict of interest while reducing a broker's incentive to steer a consumer to a higher rate.

6.  A YSP is the present dollar value of the difference between the lowest interest rate the wholesale lenders would have accepted on a particular transaction and the interest rate the broker actually obtained for the lender.  This dollar amount is usually paid to the mortgage broker.  It may also be applied to other loan-related costs, but the Board's proposal concerns only the amount paid to the broker.