Encouragingly, we have examples of some firms recognizing the potential risks of broad market disruptions, for example, if there were dramatic and unexpected price movements, or if market illiquidity set in.

I think it is naive to think that creditors will view their investments in the largest financial institutions as truly at risk. Consequently, I do not think that increased market discipline is likely to be the panacea that some believe.

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.

When times are good, as they have been for many years and banks appear well-capitalized, it is very difficult for bank supervisors to convince bankers to heed warnings that they need to behave differently. Indeed, in many situations, there may be no legal basis for requiring a change in business or lending practices. Thus I don't think we can expect expanded supervision to prevent the types of financial excesses we have seen in recent years.

In the area of supervision, I would offer two thoughts. First, the current financial crisis reinforces the importance for a central bank to have accurate and timely information on the conditions of all institutions that might make use of its liquidity facilities. Personally, I believe this is most likely to happen when the central bank has ongoing supervisory responsibilities for all institutions eligible to use its liquidity facilities. Thus, I am not a supporter of the removal of supervisory responsibilities from central banks as has happened in a number of countries. If this separation is in effect, or segmented as it is in the United States, I believe a central bank must have the legal authority to require this information from the supervisory agency on terms set by the central bank. A voluntary exchange of this information is no more likely to be effective in a financial context than it was in the U.S. intelligence community prior to 9/11.

I do think there is an issue with credit rating agencies. I've spoken on this recently. I wouldn't go far as to say banks have outsourced it lock, stock and barrel but I think in the recent rounds that we've seen that the very high credit ratings for a certain class of securities, the collaterized debt obligations based on a prime asset backed securities which were not only rated triple-A but were considered senior to Triple-A securities. I think there was an over reliance generally on that rating, but even with the banks - with some of the most sophisticated banks, as they packaged these there was an undue reliance on the credit ratings and that shouldn't happen, particularly with larger institutions that have the where with all and are in the business of making credit assessment. And I think there is a very fundamental lessons that has come out of this.

From Q&A as reported by Market News International

U.S. banks entered the period of turmoil last year pretty well capitalized and have been able to withstand large losses.

I am more skeptical of the financial strength of the GSEs, and believe that we could see substantial problems in that sector.

To date, the resulting potential capital constraints are concentrated in the largest banks with the largest exposure to securities tied to subprime mortgages. While some of the capital losses have been mitigated by new capital, the losses in combination with involuntary growth in assets can potentially restrain the willingness of these institutions to engage in activities that would further swell their balance sheet.

Because these institutions are actively engaged in structured products and loans to finance leveraged deals, it is not surprising that participants in these markets are finding tighter financial constraints. For some markets where these banks are major market makers, the unwillingness to further increase balance sheets has impacted the liquidity in those markets.

Many small and medium-sized businesses are not complaining about credit conditions. This reflects the lack of exposure that many small and medium-sized banks had to securitized products or the subprime market. However, should housing prices continue to fall, losses in prime residential mortgages and construction loans are likely to cause these institutions to be more capital constrained. Banks under $100 billion still retain significant exposure to residential mortgages and construction loans which account for 26 percent of assets or $750 billion. Should housing prices continue to fall and the housing sector get worse, it is likely that these institutions will begin being impacted more significantly.

Given falling housing prices, many financial institutions are likely less willing to be exposed to the mortgage market. One aspect of the current situation is the high LTV ratios facing many borrowers, as low down-payments and falling housing prices have made refinancing homes difficult. A possible solution would be shared appreciation loans with FHA guarantees. This approach, variants of which are currently being discussed, would provide the FHA and the lending institution with a portion of future appreciation in return for providing the FHA insurance on high LTV loans.

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 financial disruption is going to be handled in due time by the banks raising more capital and resuming the normal process of lending. That is taking place. I don't know how long it's going to take for it to be complete.

From audience Q&A, on the subprime mortgage crisis and related market turmoil. As reported by Market News International

I think the recent turmoil has shown that, in fact, banks retained a central role in the originate-to-distribute credit intermediation model. ... While banks have taken hits in the recent turmoil, their central role has been reconfirmed and their inherent strengths accentuated. The scale and scope of our larger banks and their broad earnings power have cushioned the losses. And their franchise strength has aided recapitalization.

While I see banks recovering, I see little chance that we will revert to the old approach of originate-to-hold-in-portfolio model. Market-based credit intermediation provides substantial gains from diversification and transparency that are not available in the old model. And I see little chance banks in their various forms won't remain the cornerstone institutions of our financial system.

[I] n today’s situation we are fortunate that most financial institutions have entered the current problems with significant capital cushions and that many U.S. financial institutions are moving to proactively address the problems. However, the potential for a credit crunch remains. Commercial banks are still an important source of liquidity and there are troubling developments at work.

Fundamentally, we want to encourage refinancing before a problematic reset. Banks may not have viewed this market as an engaging opportunity when mortgage brokers were going aggressively after the business, but banks may now find profitable lending opportunities in the current environment perhaps, in some cases, with guarantees provided by Federal Housing Administration (FHA) loan guarantees, or state programs.