Still, the persistence of relatively wide spreads in many markets suggests that investors continue to be worried about credit quality; the issuance of speculative-grade bonds has been scant this year; and securitization markets for many types of mortgages continue to be impaired. In addition, term bank funding markets remain under pressure as banks and other lenders in these markets conserve capital and liquidity and limit risk-taking. Banks have further tightened lending standards across a wide range of business and consumer loans.

These findings generally suggest that market participants remain wary, and in that environment, improvements in financial markets are vulnerable to negative news on the economy or the extent of credit losses. I expect further, but gradual, improvement in financial markets.

If government steps in too quickly, it could stifle innovation and hurt the financial sector. But on the other hand, if regulators wait too long, they find themselves "sweeping up after the elephant", she said.

"What is the next thing that's going to happen after we finish this crisis, and can we get ahead of it?" Braunstein said, during a panel on the subprime mortgage outlook.

As reported by Market News International

We have had this financial crisis; I think on balance as we at the Federal Reserve have provided liquidity to the marketplace, it's my thought that we have stabilized things.

This allows the other policy choices, the tax cut ... monetary policy that's in place, to strengthen the economy as it goes through the course of the year. And in that context then, our big challenge will be to make sure that we bring inflation in check and make sure that we do not repeat some of the experiences we had in the late 70s and early 80s when inflation became far too high.

As reported by Reuters.

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, with declining prices for asset-backed securities triggering margin calls, forced selling pushing prices down further, and mark-to-market losses triggering reductions in capital and escalating problems in other highly leveraged institutions.

I believe that the Fed’s liquidity operations, combined with its 325-basis-point cut in the Federal funds rate—a substantial easing of monetary policy—are having a beneficial effect on financial markets. Although overall financial conditions are still far from normal, there are some rays of hope that the strains may be easing a bit.

As we begin this year's conference, the still unsteady condition of credit markets is no doubt at the top of the mind for most.

Recent events will very likely initiate a new round of financial reforms.

No doubt some of these efforts have been appropriate. In other cases, there may have been some regulatory overshoot -- new rules doing as much or more harm than good.

As you know, the past eight months have been a very difficult period for the U.S. economy. A sharp slowdown in growth has put the economy at the brink of a recession while, at the same time, rising commodity prices have caused inflation pressures to rise considerably. And, to make matters worse, these events have occurred against the backdrop of a collapse in housing markets that has shaken financial markets around the world.

The Federal Reserve has responded to these developments aggressively. It has taken unprecedented actions to provide increased liquidity to banks and other financial market participants to maintain the functioning of financial markets. And, it has eased monetary policy considerably to try to ensure that the disruptions in financial markets do not spread to the broader economy.

Despite current difficulties, in my view there is room for optimism about the near-term outlook for the U.S. economy. Financial markets appear to have stabilized somewhat, and the economy should pick up in the second half of the year as fiscal and monetary stimulus take hold. The damage to financial markets is severe, however, and it is likely to be some time before they are able to function normally. Indeed, I believe that major changes in industry practices and a significant rethinking of financial regulation will be required if we are to avoid similar problems in the future.

Earlier, I mentioned the potential impact of the recent financial market disruptions on growth. Indeed, concern with the effects of these disruptions and, in particular, the possibility they could lead to a severe credit contraction was the principal motivation for the aggressive easing of monetary policy by the Federal Reserve over the past several months. ... Although credit conditions have tightened considerably in recent months and some markets for asset-backed securities have shut down, we have not seen as large a credit crunch as some anticipated. Indeed, outside of some mortgage markets, consumers and businesses with strong credit histories have continued to have access to credit on reasonable terms. Consequently, in my opinion, financial markets disruptions, while noteworthy, are not the major story behind the recent weakness in economic activity. Energy price increases and housing dominate this slowdown.

[T]here are reasons that suggest the economic slowdown will be short-lived. Part of the pickup in growth will likely come from the tax cuts that are going into effect currently, part from the monetary policy stimulus provided by low interest rates and part from a boost to exports from the lower dollar. Forecasters also see moderation in energy and food costs later this year, which would provide a boost to growth but also lead to lower inflation pressures.

As I indicated earlier, we are also seeing signs of stabilization in financial markets, with improved liquidity and more transactions. Still, many markets are not functioning normally, and it will take additional time for the damage to be assessed and repaired.

As to monetary policy, the current accommodative stance should be sufficient to cushion the economy from a deeper slowdown and the risks that financial disruptions could spill over to the broader economy. As the economy recovers and credit conditions improve, however, it will be necessary for the Federal Reserve to remove the policy accommodation in a timely manner. How fast this occurs will depend on whether inflation pressures moderate or intensify in the period ahead.

From the standpoint of private market discipline, this crisis has provided the first major test of securitization, complex financial instruments, risk modeling, and our new and broader market structure. Recent events indicate dismal test results: Many financial institutions and investors did not adequately judge, price or control the risks they assumed and did not prepare well for changing financial conditions.

It is a simple fact of history that, over a business cycle, markets tend toward excess optimism in which risk is seriously underestimated. In some cases, public policy is required to “bail out” undeserving parties so as to minimize the broader impact on the economy. It is also a fact that no matter the source of the financial problem, no matter the size of the institution or the region in which the problem emerges, the Federal Reserve will be part of any solution that is developed. This was the case in the ’70s, ’80s and ’90s during the foreign debt, farm, real estate and energy crises and is the case today. As a necessary principal party in prudential supervision and as the lender of last resort, the Federal Reserve is best positioned for this task.

One other important regulatory concern is that many of the steps public authorities have taken over the last year to stabilize the financial system seem likely to weaken market discipline and extend moral hazard problems to a much wider financial marketplace. A key example of this, the recent sale of Bear Stearns, seems to indicate that in a crisis situation, public authorities will not be in a position to let market discipline play out when larger financial institutions encounter problems. Bear Stearns’ collapse indicates that such phrases as “systemically important” and “too-big-to-fail” can even be applied to investment banks below the top tier.

The danger from a public policy perspective is that a much broader group of managers and creditors may now believe and act as if they have an added layer of protection from the risks they pursue. Beyond “too-big-to-fail” concerns, other market discipline and moral hazard problems may be inherent in some of the recent and more expansive proposals to support housing markets and in the actions the Federal Reserve had to take to provide liquidity to the market and expand discount window access.

What steps should market participants take to restore their disciplinary role in the financial system and prevent the depth of problems we have recently experienced? In the near term, investors can be expected to show a preference for simpler and more readily understood financial instruments, while showing a reluctance to put their money in the types of markets and investment vehicles that have caused much of the recent turmoil. They can also be expected to exert more “due diligence” and to favor the originators, rating agencies and fund managers that demonstrate a reputation for providing sound credit analysis and accurate disclosures. These are certainly some of the most apparent “lessons to be learned,” and it will take some time for our financial markets to regain the confidence of investors and meet this revised set of expectations.

Experience tells us, however, that as time passes and memories fade, market participants will always be tempted to relax their ongoing disciplinary role, particularly as any corrective steps begin to appear outmoded in a more prosperous time and as new and seemingly more profitable opportunities and investment vehicles are developed.

There are no easy answers in dealing with this “too-big-to-fail” issue, but we need to take some strong steps if we are to restore the proper balance between financial risk and return and make market discipline effective. But we must be certain that whenever a bailout cannot be avoided, it should follow also that public authorities assume senior positions with respect to stockholders and other creditors at these “too-big-to-fail” institutions.