However, as subsequent events have demonstrated, the problem was much broader than subprime lending. Large inflows of capital into the United States and other countries stimulated a reaching for yield, an underpricing of risk, excessive leverage, and the development of complex and opaque financial instruments that seemed to work well during the credit boom but have been shown to be fragile under stress.

[A] new and unwelcome wrinkle to the financial turmoil is occurring in many short-term credit markets − something you might call a "liquidity lock." By liquidity lock, I am referring to extreme risk aversion by many investors and institutions, which makes short-term financing difficult to come by for even the most creditworthy firms – including financing for very short maturities, measured in days.

In the case of Lehman Brothers, a major investment bank, the Federal Reserve and the Treasury declined to commit public funds to support the institution.  The failure of Lehman posed risks.  But the troubles at Lehman had been well known for some time, and investors clearly recognized--as evidenced, for example, by the high cost of insuring Lehman's debt in the market for credit default swaps--that the failure of the firm was a significant possibility.  Thus, we judged that investors and counterparties had had time to take precautionary measures.

I believe that under the Treasury program auctions and other mechanisms could be designed that will give the market good information on what the hold-to-maturity price is for a large class of mortgage-related assets.  If the Treasury bids for and then buys assets at a price close to the hold-to-maturity price, there will be substantial benefits.

• First, banks will have a basis for valuing those assets and will not have to use fire-sale prices. Their capital will not be unreasonably marked down.
• Second, liquidity should begin to come back to these markets.
• Third, removal of these assets from balance sheets and better information on value should reduce uncertainty and allow the banks to attract new private capital.
• Fourth, credit markets should start to unfreeze. New credit will become available to support our economy.
• And fifth, taxpayers should own assets at prices close to hold- to-maturity values, which minimizes their risk.

Now, how to make this work? To make this work, we do need flexibility in design of mechanisms for buying assets and from whom to buy. We do not know exactly what the best design is. That will require a consultation with experts and experience with alternative approaches.  Second, understanding the concerns and the -- and the worries of the committee, we cannot impose punitive measures on the institutions that choose to sell assets. That would eliminate or strongly reduce participation and cause the program to fail.  Remember, the beneficiaries of this program are not just those who sell the asset but all market participants and the economy as a whole.

From the Q&A session

Let me say that looking only at the Federal Funds rate during periods of significant economic headwinds will, in my view, provide a misleading gauge of the degree of monetary stimulus that the Federal Reserve has put in place.  At such times, a low Federal Funds rate does not signal a particularly accommodative monetary policy, but rather offsets some of the contraction that would otherwise occur as financial institutions tighten credit standards and offer borrowing rates with a spread over the Federal Funds rate that is larger than usual (in other words, larger than would be the case outside of credit crunch conditions).

That said, make no mistake: in my view, credit conditions would likely be much worse if the Federal Reserve had not lowered the Federal Funds rate and taken several innovative steps to enhance liquidity in the marketplace – steps like opening our new Term Auction Facility and other facilities that complement our traditional “Discount Window” for banks.

The liquidity tools of central banks and the emergency powers of other public authorities were created in recognition of the fact that individual institutions, including those central to payments and funding mechanisms, cannot protect themselves fully from an abrupt evaporation of access to liquidity or ability to liquidate assets. The existence of these tools and their use in crises, however appropriate, creates moral hazard by encouraging market participants to engage in riskier behavior than they would have in the absence of the central bank’s backstop. To mitigate this effect on risk-taking, strong supervisory authority is required over the consolidated financial entities that are critical to a well-functioning financial system.

A more resilient financial system will also require a framework for dealing with the failure of financial institutions. For entities that take deposits, we have a formal resolution framework in place...we need a companion framework for facilitating the orderly unwinding of other types of regulated financial institutions where failure may pose risks to the stability of the financial system.

If you've got a squirt gun in your pocket, you may have to take it out. If you've got a bazooka and people know you've got it, you may not have to take it out. You're not likely to take it out. I just say that by having something that's unspecified, it will increase confidence and by increasing confidence it will greatly reduce the likelihood it will ever be used.

As reported by Reuters.

We need complementary efforts to mitigate risks to the financial system in the event that services, including Tri-Party Repo, provided by one of the two major clearing banks for government securities were suddenly disrupted or terminated. A related challenge is the vulnerability of the repo markets, including Tri-Party Repo, as a continuous funding source. As we have witnessed, liquidity in the repo markets can evaporate suddenly if counterparties become unwilling to provide even short-term secured financing because of uncertainty. Efforts are needed to ensure that both borrowers and lenders strengthen their credit, operational and liquidity risk management practices.

Broadly speaking, we believe that primary dealers are strengthening liquidity and capital positions to better protect themselves against extreme events. We also believe their management has learned some valuable lessons from the events of the recent financial turmoil that should translate into better risk management. We continue to monitor the effect of the PDCF and are studying a range of options going forward.

As the probability of severe damage to the financial system recedes, the likelihood of a measurable contraction in growth this year has lessened. These conditions complicate the inflation outlook, in which significant economic slack had been seen as helping to keep inflation in check.

One of the central objectives in reforming our regulatory framework should be to mitigate the fragility of the system and to reduce the need for official intervention in the future. I know that many hope and believe that we could design our system so that supervisors would have the ability to act preemptively to diffuse pockets of risk and leverage. I do not believe that is a desirable or realistic ambition for policy. It would fail, and the attempt would entail a level of regulation and uncertainty about the rules of the game that would offset any possible benefit. I do believe, however, that we can make the system better able to handle failure by making the shock absorbers stronger.    

The structure of the financial system changed fundamentally during the boom, with dramatic growth in the share of assets outside the traditional banking system. This non-bank financial system grew to be very large, particularly in money and funding markets. In early 2007, asset-backed commercial paper conduits, in structured investment vehicles, in auction-rate preferred securities, tender option bonds and variable rate demand notes, had a combined asset size of roughly $2.2 trillion. Assets financed overnight in triparty repo grew to $2.5 trillion. Assets held in hedge funds grew to roughly $1.8 trillion. The combined balance sheets of the then five major investment banks totaled $4 trillion.

In comparison, the total assets of the top five bank holding companies in the United States at that point were just over $6 trillion, and total assets of the entire banking system were about $10 trillion.

This parallel system financed some of these very assets on a very short-term basis in the bilateral or triparty repo markets. As the volume of activity in repo markets grew, the variety of assets financed in this manner expanded beyond the most highly liquid securities to include less liquid securities, as well. Nonetheless, these assets were assumed to be readily sellable at fair values, in part because assets with similar credit ratings had generally been tradable during past periods of financial stress. And the liquidity supporting them was assumed to be continuous and essentially frictionless, because it had been so for a long time.

I believe the severity and complexity of this crisis makes a compelling case for a comprehensive reassessment of how to use regulation to strike an appropriate balance between efficiency and stability. This is exceptionally complicated, both in terms of the trade-offs involved and in building the necessary consensus in the United States and the world. It is going to require significant changes to the way we regulate and supervise financial institutions, changes that go well beyond adjustments to some of the specific capital charges in the existing capital requirement regime for banks.

The dramatic recent expansion in Federal Reserve lending raises the possibility that market participants view future access to Fed credit as having been substantially broadened. For evidence, market participants could point to the fact that entities formerly viewed as unlikely to have access to the discount window, such as the primary dealer subsidiaries of investment banks, have now been granted access...In my view, there is value in communicating policy intentions clearly. Deliberate imprecision — the so-called "constructive ambiguity" approach — leaves it to market participants to draw inferences for future policy from our past actions. Without an articulated statement of intention regarding lending policy, the time consistency problem is likely to be a difficult challenge because it will be hard to resist the future temptation to mitigate financial market stresses when they arise.

   ``The relatively modest changes, reforms, related to the Libor panel were anticipated so I was not at all surprised on
where they came out.
     ``As I step back from this I think the mechanism of setting the Libor rate is an enormously important part of our financial system. Even if it says `London' at the beginning of the phrase, it has an enormous effect on U.S. interest rates, including mortgage resets and corporate borrowing.
     ``It has had over the years a record of serving well and with some tweaks and reforms I think it can continue to serve. It would be extremely difficult to move wholesale to a different index.''

From Q&A session with the press, as reported by Bloomberg News