I would be the first to acknowledge that some things have changed in our financial markets, but financial crises continue to occur for the same reasons as always – over-optimism, excessive debt and leverage ratios, and misguided incentives and perspectives – and our solutions must continue to address these basic problems.

Our judgment has been and continues to be that, in this time of severe market and economic stress, the failure of AIG would impose unnecessary and burdensome losses on many individuals, households and businesses, disrupt financial markets, and greatly increase fear and uncertainty about the viability of our financial institutions.  Thus, such a failure would deepen and extend market disruptions and asset price declines, further constrict the flow of credit to households and businesses in the United States and in many of our trading partners, and materially worsen the recession our economy is enduring.

With the economy likely to shrink significantly in the first half of this year, the unemployment rate rising higher than 8.5 percent is, unfortunately, very likely.
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I believe that below-potential growth is likely to persist until financial markets and financial institutions can resume more normal functioning.  So in addition to the other steps being taken to stimulate the economy, we need to be sure that actions to support the stability of the financial system are taken without delay – and, in the slightly longer term, that regulatory frameworks are thoughtfully reformed.

It is very important to note that the largest components of the expansion of the Federal Reserve balance sheet are likely to become unappealing to market participants as financial conditions improve and interest rate spreads decline.  Thus, much of the Fed’s balance-sheet expansion should be reversed as we see the return of more normal trading.

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(T)he Federal Reserve programs I have described today are intended to reduce the unusually large spreads created by financial disruptions, so that the cost of credit for a variety of borrowers returns to the level we would expect with more normalized functioning of credit markets.  The Federal Reserve’s recent monetary policy actions, combined with the fiscal stimulus package that the government recently enacted, should in my view help pull the economy out of the severe recession we have been experiencing.

(M)arket disruptions clearly remain, and most spreads between private lending rates and comparable-maturity risk-free government debt are still quite elevated relative to where they were before the crisis. Of course, we would not expect spreads and other lending terms to return to those prevailing before the crisis—a period when risk was clearly underpriced. Nevertheless, current spreads and terms seem to be well above where the "new normal" will end up.

History clearly shows, and recent experience confirms, that--because of the dependence of modern economies on the flow of credit--serious financial instability imposes disproportionately large costs on the broader economy.  The rationale for public investment in the financial industry is not, therefore, any special regard for managers, workers, or investors in that industry over others, but rather the need to prevent a further deterioration in financial conditions that would destroy jobs and incomes in all industries and regions. That said, the public is entitled to demand that policymakers take near-term, concrete actions to ensure that we do not face a similar crisis in the future.  An important part of those actions should be to create a stronger supervisory and regulatory system in which gaps and unnecessary duplication in coverage are eliminated, lines of supervisory authority and responsibility are clear, and oversight powers are sufficient to curb excessive leverage and risk-taking, particularly in systemically critical institutions.  The Federal Reserve stands ready to work closely with the Congress to achieve meaningful and effective regulatory reform.

By supporting short-term credit markets, the Federal Reserve is signaling its determination to take appropriate actions to prevent “seize-ups” in financial markets, reducing the risk premium. In short, we have seen improvements of late in the functioning of many short-term credit markets, and I expect this improvement will continue.

Confronted with a barrage of criticism from lawmakers, former officials and even some of his staff, Cox said he took pride in his measured response to the market turmoil.

"What we have done in this current turmoil is stay calm, which has been our greatest contribution -- not being impulsive, not changing the rules willy-nilly, but going through a very professional and orderly process that takes into account unintended consequences and gives ample notice to market participants," Cox said. This caution, he added, "has really been a signal achievement for the SEC."

Taking a swipe at the shifting response of the Treasury and Fed in addressing the financial crisis, he said: "When these gale-force winds hit our markets, there were panicked cries to change any and every rule of the marketplace: 'Let's try this. Let's try that.' What was needed was a steady hand."

Cox said the biggest mistake of his tenure was agreeing in September to an extraordinary three-week ban on short selling of financial company stocks. But in publicly acknowledging for the first time that this ban was not productive, Cox said he had been under intense pressure from Treasury Secretary Henry M. Paulson Jr. and Fed Chairman Ben S. Bernanke to take this action and did so reluctantly. They "were of the view that if we did not act and act at that instant, these financial institutions could fail as a result and there would be nothing left to save," Cox said.

As reported by the Washington Post.

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.

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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.

(W)hile credit supply concerns are real, the weakened state of the economy appears to be the more serious challenge facing most small businesses in the current environment.  Importantly, there is some evidence that concern over access to credit is relatively stronger at larger businesses.

We have long recommended that policymakers evaluate policies to address TBTF against their ability to appropriately reduce the likelihood that government will provide support to nominally uninsured creditors of large financial institutions. I believe that policymakers provide such support in order to limit the fallout, or spillovers, that arise when a large financial institution gets into trouble. So effective TBTF policies are ones that allow policymakers to better manage the spillovers from the collapse or failure of a large financial firm.

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I'm skeptical of claims that the Federal Reserve or anyone else should have foreseen the situation as it actually played out. I also strongly support the actions the Federal Reserve has taken in response to these events, even with the undesired side effect of intensifying the TBTF problem. A significant issue, though, is what reforms should policymakers introduce to address the magnified TBTF problem? One criterion is that we consider reforms that would have helped prepare policymakers for the financial fallout they have faced over the last year or so, and it is my conviction that several reforms I have previously articulated fit that bill.

The proximate cause of the financial turmoil was the steep increase and subsequent decline of house prices nationwide, which, together with poor lending practices, have led to large losses on mortgages and mortgage-related instruments by a wide range of institutions.  More fundamentally, the turmoil is the aftermath of a credit boom characterized by underpricing of risk, excessive leverage, and an increasing reliance on complex and opaque financial instruments that have proved to be fragile under stress.

Over the past year, we have witnessed the deteriorating performance of mortgages and mortgage-backed securities spill over to other segments of our financial markets. Market participants have reassessed the risk profiles of other similarly structured assets, and prices of these securities have declined as well. This cascading process of re-pricing has had a detrimental impact on liquidity and capital positions in a wide range of financial institutions and markets in the United States and around the world.

I am optimistic that this multipronged approach {monetary easing with global central bank cooperation} is laying the groundwork for a return to more normal functioning in financial markets and a restoration of vigorous economic growth. The initial reaction has been positive, but it will take some time before we know to what extent the current stresses in the financial sector are being resolved. Over time, financial firms will need to bolster profits to offset losses and attract capital, to delever by reducing debt relative to equity, and in many cases to consolidate through mergers and acquisitions. All of this points to a prolonged period of cautious lending and a high cost of capital relative to benchmark interest rates like the federal funds rate, even as market functioning improves.

Financial crises are hardly unprecedented.  In fact, over half of all International Monetary Fund member countries have experienced a systemic banking crisis since 1980. But the financial crisis that began here in August 2007 has intensified in recent weeks, becoming exceptionally severe and global in its dimensions.  Its potential ramifications for the economic well-being of citizens here and around the globe are a matter of grave concern.