My guess is that the current framework for monetary policy--with innovations, no doubt, to further improve the ability of central banks to communicate with the public--will remain the standard approach, as its benefits in terms of macroeconomic stabilization have been demonstrated. However, central banks are also heeding the broader lesson, that the maintenance of financial stability is an equally critical responsibility. Central banks certainly did not ignore issues of financial stability in the decades before the recent crisis, but financial stability policy was often viewed as the junior partner to monetary policy. One of the most important legacies of the crisis will be the restoration of financial stability policy to co-equal status with monetary policy.

...

How should these two critical functions fit together?

At an institutional level, as I have already suggested, the two functions are highly complementary. Monetary policy, financial supervision, and lender-of-last-resort policies all benefit from the sharing of information and expertise...

An important debate for the future concerns the extent to which it is useful for central banks to try to make a clear distinction between their monetary and financial stability responsibilities, including designating a separate set of policy tools for each objective...

In practice, the distinction between macroeconomic and financial stability objectives will always be blurred to some extent, given the powerful interactions between financial and economic conditions... In my view, the issue is not whether central bankers should ignore possible financial imbalances--they should not--but, rather, what "the right tool for the job" is to respond to such imbalances. 

The evolving consensus, which is by no means settled, is that monetary policy is too blunt a tool to be routinely used to address possible financial imbalances; instead, monetary policy should remain focused on macroeconomic objectives, while more-targeted microprudential and macroprudential tools should be used to address developing risks to financial stability, such as excessive credit growth.

I would suggest that the financial stability issues raised in 2008, and which have become increasingly prevalent of late, require a reexamination of issues that influence the stability of short-term credit markets.

I would argue that progress on the liquidity front has not progressed as far as desired.First, many banks remain dependent on short-term funding to finance longer-term assets from counterparties that tend to flee at the first signs of distress. In particular, money market mutual funds remain vulnerable to runs. Such runs can occur even when the underlying risks remain negligible, making money market mutual funds a source of instability. Just a question from an investor about the fund manager’s exposures can cause the fund manager to withdraw funding from a counterparty. This may be market discipline, but it does not operate in a way that makes the financial system more stable.

MODERATOR: And a closing question, this one submitted by Steve Sanger, former CEO of General Mills and a member of our economic club board. How would you rate actor Paul Giamatti's portrayal of you and, for that matter, the portrayal of other principals in the recent movie "Too Big to Fail"?

(LAUGHTER)

BERNANKE: I didn't see that movie; I saw the original.

(LAUGHTER)

(APPLAUSE)

BERNANKE:  I think Paul Giamatti is an excellent actor.  And, in fact, I met him. He asked to come meet with me, so I had him over for lunch at the Federal Reserve. And -- and the first thing I found out about him was that his father was the commissioner of baseball, Bart Giamatti. So what do you think we talked about for the whole lunch?

Under the Dodd-Frank legislation a group of regulators, the Financial Stability Oversight Council, is now tasked with providing financial stability oversight. However, as I noted at the outset, financial stability was never defined in the legislation. This leaves some ambiguity on how broadly or narrowly financial stability should be defined.

Important as it is, moral hazard is not the only worry engendered by very large, highly interconnected firms in financial markets. Assuming that a government overcomes time-consistency problems and credibly binds itself not to rescue these institutions, their growth would presumably be somewhat circumscribed. But it is possible, perhaps likely, that some combination of scale and scope economies, oligopolistic tendencies, path dependence, and chance would nonetheless produce a financial system with a number of firms whose failure could bring about the very serious negative consequences for financial markets described by the domino and fire-sale effects.

It would be unrealistic, even dangerous, to believe that asset bubbles, excessive leverage, poor risk assessment, and the crises such phenomena produce can all be prevented. The goal of the regulatory regime should be to reduce the likely incidence of such crises and, perhaps more importantly, to limit their severity when they do occur. This argues for fostering a financial sector capable of withstanding systemic stresses and still continuing to provide reasonably well-functioning capital intermediation through lending and other activities. The aim is not to avoid all losses or any retrenchment in lending and capital markets. It is to prevent financial markets from freezing up as they did in the latter part of 2008.

[Despite provisions in the Dodd-Frank bill,] the FDIC retains considerable discretion in the use of funds to limit losses to some creditors, and the Treasury can invoke orderly resolution for firms that have not been subject to enhanced regulation. The Fed also retains some discretionary power to lend to non-bank entities. This creates continued uncertainty about possible rescues, as well as gaps in our ability to provide clear, credible constraints on the safety net.

For the financial industry, your core challenge is to restore the trust and confidence of the American people and your customers and investors around the world.

You will have to make your own decisions about how best to do that, but, I thought, given that I'm here in New York, I'd offer a few suggestions as an interested observer...

Focus on improving your financial position so that your financial ratings, your cost of capital, the amount you have to pay to borrow, all reflect your own financial strength and earnings prospects, not the false expectation that the government will be there in the future to rescue you.

The quest for such a financial conditions index, or FCI, capable of summarizing broad financial conditions is hardly new. Indeed, market analysts routinely compile a number of such indexes. But, in the aftermath of the recent crisis, further development of financial conditions indexes has attracted renewed interest among economic researchers. The holy grail of this endeavor is to formulate a single number that measures the combined influence on the economy of a broad array of financial variables.

Extensive study of banking crises shows that they tend to be “protracted affairs” with surprisingly similar, if unpleasant, contours. Downturns average four years, during which the unemployment rate rises an average of 7 percentage points. The peak-to-trough decline in output averages 9 percent.

Governments around the world have shown they're going to stand behind (troubled) large financial firms...government guarantees mean there won't be a renewal of the financial panic seen in the fall of 2008.

A key point is that the systemic regulator cannot just look institution by institution, but needs to think about the potentially difficult trends emerging across a swath of interconnected institutions and their counterparties. And while it may go without saying, for a systemic regulator to be effective, the regulator needs to be able to identify whether actual systemic problems are emerging. This involves, in part, assessing the “feedback effects” that might result from initial problems.

[B]efore we set clear and explicit objectives for financial stability, we first must be clear about what we mean by financial stability. Policymakers cannot and should not try to prevent all types of financial instability. Indeed, the economy benefits when financial institutions and markets take on and manage risk. That means inevitably some firms will fail. As my friend the economist Allan Meltzer has said, "Capitalism without failure is like religion without sin. It doesn't work."  Our goal should not be to try to prevent every failure, but rather to reduce the systemic risks to the financial system that a failure may create.

[I]t must be recognized that there are many types of banks in the United States with different specializations, geographic concentrations, and comparative advantages. Consequently, the extraordinary stress in the financial system, the downturn in the U.S. and global economies, and the associated reductions in asset values have affected each bank differently.