At the Federal Reserve and at other bank regulatory agencies, our job is to reinforce the incentives and actions that are building a more resilient financial system. We need to make sure that regulatory minimum capital requirements and liquidity management plans protect reasonably well against shocks becoming systemic. Our supervisory guidance needs to be in place to prevent backsliding when, over the coming years, the memories and lessons of the current market turmoil fade, as they certainly will.

To these ends, we are reexamining a host of things ranging from Basel II to liquidity to transparency. Working with our domestic and international colleagues, we are looking to raise the Basel II capital requirements on specific exposures that have been troublesome, such as super senior CDOs of asset-backed securities and off-balance-sheet commitments. We are looking to the Basel Committee on Banking Supervision to update its guidance on liquidity management in light of the recent experience. And we and our supervisory colleagues are looking to require better disclosures of off-balance-sheet commitments and of valuations of complex structured products.

So we must worry about excessive leverage and susceptibility to runs not only at banks but also at securities firms. To be sure, investment banks are still different in many ways from commercial banks. Among other things, their assets are mostly marketable and their borrowing mostly secured. Ordinarily, this should protect them from liquidity concerns. But we learned that short-term securities markets can suddenly seize up because of a loss of investor confidence, such as in the unusual circumstances building over the past six months or so. And investment banks had no safety net to discourage runs or to fall back on if runs occurred. Securities firms have been traditionally managed to a standard of surviving for one year without access to unsecured funding. The recent market turmoil has taught us that this is not adequate, because short-term secured funding, which these firms heavily rely upon, also can become impaired.

With many securities markets not functioning well, with the funding of investment banks threatened, and with commercial banks unable and unwilling to fill the gap, the Federal Reserve exercised emergency powers to extend the liquidity safety net of the discount window to the primary dealers.³ Our goal was to forestall substantial damage to the financial markets and the economy. Given the changes to financial markets and banking that we've been discussing this morning, a pressing public policy issue is what kind of liquidity backstop the central bank ought to supply to these institutions. And, assuming that some backstop is considered necessary because under some circumstances a run on an investment bank can threaten financial and economic stability, an associated issue is what sorts of regulations are required to make the financial system more resilient and to avoid excessive reliance on any such facility and the erosion of private-sector discipline.

...

Whatever type of backstop is put in place, in my view greater regulatory attention will need to be devoted to the liquidity risk-management policies and practices of major investment banks. In particular, these firms will need to have robust contingency plans for situations in which their access to short-term secured funding also becomes impaired. Commercial banks should meet the same requirement. Implementation of such plans is likely to entail substitution of longer-term secured or unsecured financing for overnight secured financing. Because those longer-term funding sources will tend to be more costly, both investment banks and commercial banks are likely to conclude that it is more profitable to operate with less leverage than heretofore. No doubt their internalization of the costs of potential liquidity shocks will be costly to their shareholders, and a portion of the costs likely will be passed on to other borrowers and lenders. But a financial system with less leverage at its core will be a more stable and resilient system, and recent experience has driven home the very real costs of financial instability.

Although our actions appear to have helped stabilize the situation, financial markets remain under considerable stress. For example, many lenders have been reluctant to provide credit to counterparties, especially leveraged investors, and have increased the amount of collateral they require to back short-term security financing agreements. Credit availability has also been restricted because some large financial institutions, including some large commercial and investment banks, have reported substantial losses and asset write-downs, which reduced their available capital. The capacity and willingness of some large banks and other financial institutions to extend new credit has also been limited by the reduced availability of external funding from the capital markets for originated assets. The resulting unplanned increases in their balance sheets have strained their capital, thus reducing lending capacity. The good news is that several of these firms have been able to raise new capital, and others are in the process of doing so. However, market stresses are likely to continue to weigh on lending activity in the near future.

The current economic environment underlines not just the importance of education but the need for improved economic and financial literacy. I am not the first, nor will I be the last, to make this plea. As an economist, I have a particular interest in economic and financial education. The events of the last decade, as well as our current economic and financial situation, have reinforced my sense of urgency in this regard.

[W]e should recognize that Fed-supplied liquidity is a poor substitute for private-sector-supplied liquidity.  When liquidity flows among private-sector participants, the players can more judiciously assess risk and reward, more adroitly learn from the recent turmoil to strengthen the resiliency of credit intermediation, and more ably allocate capital to its most productive uses in the real economy.  Moreover, Fed-provided liquidity should not be mistaken for capital.  

Credit is threatening to displace liquidity as the primary antagonist. A credit crunch, particularly for small businesses and consumers, poses meaningful downside risks to the real economy. And market participants are struggling to assess the possibility that the narrative turns into a multi-act, macroeconomic drama.

[L]et me explore three of the most trenchant and overlapping plot lines, none of which seem to avail themselves readily to a speedy resolution. First, a striking loss of confidence is affecting financial market functioning. Second, the business models of many large financial institutions are in the process of significant re-examination and repair. Third, the Federal Reserve is exercising its powers to mitigate the effects of financial turmoil on the real economy. This third plot line, however necessary, will not, in and of itself, ensure a more durable return of trust to our financial architecture. In my view, public liquidity is an imperfect substitute for private liquidity. That is, only when the other plot lines advance apace--meaning that significant, private financial actors return to their proper role at center stage--will credit market functioning and support for economic growth be fully restored. And for that to happen, as I am confident it will, we will find that the financial markets and financial firms are outfitted quite differently.

More fundamentally, in my view, funding market disruptions reflect a striking decline in confidence in the financial architecture itself. Perhaps an analogue to banking systems without deposit insurance is appropriate: Depositors withdraw funds if they believe others will act similarly. In short-term credit markets with minimal liquidity support, investors balk if they lose confidence in other investors' willingness to roll maturing paper. Even when liquidity support exists, it may well prove insufficient to address market-wide concerns. ... After all, a loss in confidence can be completely rational: Illiquidity forces issuers to sell assets into distressed markets.

Market participants now seem to be questioning the financial architecture itself. The fragility of short-term credit markets is a powerful manifestation of that loss of confidence. There are some encouraging, early signs of repair, but regaining the confidence that markets require will take time, and perhaps uncomfortably to some, patience. It may also require new forms of credit intermediation.

Volatility is generally a friend, not a foe, of market functioning. It should not be treated as an externality from which we suffer. Volatility, absent destabilizing moves, should be allowed to effectuate change in the financial architecture of private markets. Only then, I suspect, will a more robust recovery in market liquidity, investor confidence, and real economic activity be achieved.

If you've seen one financial crisis, you've seen one financial crisis ... This does appear to be different.

From Q&A as reported by Reuters

We have to find a better balance between market discipline and regulation in our financial system, a better balance between efficiency and innovation and reserves and stability.
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The best defence is to make sure you get the incentives right so that financial institutions hold larger cushions, larger shock absorbers, in good times, against conditions of stress. Hard to do, complicated to figure out how to do it well - but that's the critical objective.

As reported by Reuters

The market is still adjusting, the turmoil has not yet settled down ... It's still a fragile situation out there.

As reported by Bloomberg News

We will not experience anything remotely like that in the United States today ... We are certainly going to make sure that the financial system remains in good functioning order.

From Q&A as reported by Market News International and Reuters, on comparisons to the Great Depression

The Fed has made some tough judgment calls lately, and, having been party to making those calls, I can assure you they certainly were not made lightly. In principle, we know that the market should decide the winners and losers, who survives and who fails. I am a big fan of Winston Churchill. “It is always more easy to discover and proclaim general principles than to apply them,” Churchill said. I now know full well what he meant.