[L]et me close by addressing a question that often arises about the use of a supervisory stress test, such as those conducted by the Fed, with common scenarios and models. Such a test may create the possibility of, in former Chairman Bernanke's words, a "model monoculture," in which all models are similar and all miss the same key risks. Such a culture could possibly create vulnerabilities in the financial system. At the Fed we try to address this issue, in part, through appropriate disclosure about the supervisory stress test. We have published information about the overall framework employed in various aspects of the supervisory stress test, but not the full details that banks could use to manage to the test. This--making it easier to game the test--is the potential negative consequence of transparency that I alluded to earlier.

Innovative new opportunities for risk-taking will always emerge as financial markets and economies evolve, and it is asking too much to expect front-line supervisors to forever substitute for well-aligned incentives. Moreover, stronger restraints on risk-taking increase the incentive for market participants to find a way to operate beyond the scope of regulation. Expanding regulation to chase down fragility wherever it appears is not a promising strategy.

For that reason, I believe community banks have a vested interest in seeing that regulatory reforms move ahead to ensure that the largest banks are well capitalized, well supervised, well managed and subject to failure. Achieving that end will serve the public well. While that work is underway, regulators must also allow examiner judgment and common sense to play a greater role in their supervisory regimes for community banks.

I'm often told that the world has become more complicated, that we have too many banks in the U.S. and that we cannot go back to less-complex and more-straightforward regulation and rules and greater supervisory judgment. I'm not convinced. One of the best responses to that assertion was from Sir Mervyn King, the former governor of the Bank of England. Although his reference was made in the context of finding a solution to the issue of too big to fail, the same might be said for addressing the regulatory environment more generally. He said, There are those who claim that such proposals are impractical. It is hard to see why. What does seem impractical, however, are the current arrangements.

So we have finalized our Basel III capital requirements that significantly increase the quality and quantity of capital in the banking system. Even before we did that, through our stress tests we have worked to ensure that especially the largest and most systemic institutions have the ability to not only survive a very adverse stress to the system but also to lend and support the needs of the economy through such a stress. The amount of capital in the banking system has basically doubled since 2009.

Several financial sector reform programs were prepared within a few months after the Lehman Brothers failure. These programs were supported by national policymakers, including the community of bank supervisors. The programs--national and international--covered some or all of the following nine areas:

(1) to strengthen the stability and robustness of financial firms, "with particular emphasis on standards for governance, risk management, capital and liquidity"
(2) to strengthen the quality and effectiveness of prudential regulation and supervision;
(3) to build the capacity for undertaking effective macroprudential regulation and supervision;
(4) to develop suitable resolution regimes for financial institutions;
(5) to strengthen the infrastructure of financial markets, including markets for derivative transactions;
(6) to improve compensation practices in financial institutions;
(7) to strengthen international coordination of regulation and supervision, particularly with regard to the regulation and resolution of global systemically important financial institutions, later known as G-SIFIs;
(8) to find appropriate ways of dealing with the shadow banking system; and
(9) to improve the performance of credit rating agencies, which were deeply involved in the collapse of markets for collateralized and securitized lending instruments, especially those based on mortgage finance.

There are many models of regulatory coordination, but I shall focus on only two: the British and the American. As is well known, the United Kingdom has reformed financial sector regulation and supervision by setting up a Financial Policy Committee (FPC), located in the Bank of England; the major reforms in the United States were introduced through the Dodd-Frank Act, which set up a coordinating committee among the major regulators, the Financial Stability Oversight Council (FSOC).

In discussing these two approaches, I draw on a recent speech by the person best able to speak about the two systems from close-up, Don Kohn. Kohn sets out the following requirements for successful macroprudential supervision: to be able to identify risks to financial stability, to be willing and able to act on these risks in a timely fashion, to be able to interact productively with the microprudential and monetary policy authorities, and to weigh the costs and benefits of proposed actions appropriately. Kohn's cautiously stated bottom line is that the FPC is well structured to meet these requirements, and that the FSOC is not. In particular, the FPC has the legal power to impose policy changes on regulators, and the FSOC does not, for it is mostly a coordinating body.

After reviewing the structure of the FSOC, Kohn presents a series of suggestions to strengthen its powers and its independence. The first is that every regulatory institution represented in the FSOC should have the goal of financial stability added to its mandate. His final suggestion is, "Give the more independent FSOC tools it can use more expeditiously to address systemic risks." He does not go so far as to suggest the FSOC be empowered to instruct regulators to implement measures somehow decided upon by the FSOC, but he does want to extend its ability to make recommendations on a regular basis, perhaps on an expedited "comply-or-explain" basis.

There are many important regulatory requirements applicable to large financial firms. Boards must of course be aware of those requirements and must help ensure that good corporate compliance systems are in place. But it has perhaps become a little too reflexive a reaction on the part of regulators to jump from the observation that a regulation is important to the conclusion that the board must certify compliance through its own processes. We should probably be somewhat more selective in creating the regulatory checklist for board compliance and regular consideration. One example, drawn from Federal Reserve practice, is the recent supervisory guidance requiring that every notice of a "Matter Requiring Attention" (MRA) issued by supervisors must be reviewed, and compliance signed off, by the board of directors. There are some MRAs that clearly should come to the board's attention, but the failure to discriminate among them is almost surely distracting from strategic and risk-related analyses and oversight by boards.

Why was it that the banking system in this part of the country was, apparently, especially vulnerable, and what lessons can be drawn from this experience?

At the risk of some oversimplification, I'll propose four takeaways.

First, concentrations can be deadly. Many of the banks that failed, especially around Atlanta, were relatively young banks that became highly concentrated in residential real estate loans, particularly acquisition, development, and construction, or ADC loans.

Second, many of the banks that failed were excessively reliant on wholesale funding. The median wholesale funding-to-asset ratio of the Georgia banks that failed was 30 percent. Hot money can burn you.

Another factor that contributed to failures was inexperience with severe conditions along with overdependence on collateral values without an understanding of cash flows under various scenarios. I'm a former commercial banker. I was taught that cash generation repays loans, and analysis of the borrower's ability to repay is basic...

Finally, many of the failed banks suffered from weak governance. Banks need board members who understand their role as directors. Directors as a group set policy, define the risk appetite of the bank, and hold management accountable for risk management.

It is too easily assumed that financial models, stress tests and macroprudential supervision will provide smarter supervision and identify what is presumed to have been missed by examiners in the run-up to the 2008 financial crisis. However, a more thorough analysis suggests that the largest banks were more vulnerable because regulators relied too heavily on erroneous assumptions about the quality of governance and controls over incentives, sophistication and measurement of risk management, and the strength of market discipline. As a result, regulators had already given up on the type of full-scope examinations that smaller institutions typically experience. Prior to 2008, most of the supervisory emphasis centered on a large institutions models and risk weights, and far less effort was given to a thorough examination and critical analysis of its loan portfolio, funding strategies and exposure to exotic risks such as synthetic derivatives. The Dodd-Frank Act requires enhanced prudential standards for firms in the United States that pose elevated risk to financial stability. These macroprudential efforts are worthy exercises, but no matter the tool, experience and informed judgments provided by trained and experienced staff are required to meet todays heightened supervisory expectations. Data and models provide information and choices that must be evaluated in the context of the more subjective or qualitative elements of the organization, such as the quality of internal controls and protocols, management and organizational culture.

MCKEE: What do you think of the Brown-Vitter legislation, a 15 percent capital ratio for the biggest banks?

DUDLEY: I think that this is all about costs versus benefits. You could - you could go with a proposal that raised capital requirements on large institutions a lot, which is what the Brown-Vitter legislation does. There are going to be consequences of that. It's going to drive up the cost of credit in the economy. It's going to probably tighten credit conditions for a while. And so you have to weigh that cost versus - versus the benefit of reducing the probability of these firms failing.

I think the - the Dodd-Frank Act basically envisions that there's a more efficient way to achieve the same outcome of ending too big to fail. We all want to end too big to fail, but we should also want to end it in the most efficient way possible, the way that causes the least damage to the economy, that causes the least increase in the spread between the cost of deposits and borrowing.

While some of the more notorious pre-crisis components of the shadow banking system are probably gone forever, current examples include money market funds, the triparty repo market, and securities lending.

From the perspective of financial stability, the parts of the shadow banking system of most concern are those that create assets thought to be safe, short-term, and liquid--in effect, cash equivalents. For a variety of reasons, demand for such assets has grown steadily in recent years, and is not likely to reverse direction in the foreseeable future. Yet these are the assets whose funding is most likely to run in periods of stress, as investors realize that their resemblance to cash or insured deposits in normal times has disappeared in the face of uncertainty about their underlying value.

[A] quick resolution for European sovereign debt concerns and banking problems may remain elusive, and the same for the large deficit problems in many countries. This suggests that slow growth is likely to continue for quite some time.

European stocks were badly impacted by the financial shock from the U.S. during the last financial crisis. Were there to be a serious financial shock from Europe, these correlations suggest it is quite likely that it would have a large impact on financial stocks and the broader stock market in the United States. Such stock price declines could impact households and businesses on both sides of the Atlantic, and problems in Europe could potentially cause a more significant retrenchment by European financial institutions operating in the United States.

[W]hile Asian banks did not have a high correlation with U.S. and European bank stock returns during 2007 and early 2008, Asian banks are likely to be more impacted now should a significant shock occur in Europe. European bank presence in Asia has been rising, and Japan and Taiwan have relatively large claims in Europe. In short, I would say that as interconnectedness increases globally, it will be difficult for any one region to insulate itself from financial strains or crises elsewhere in the world.

Without commenting on the specifics of any of these individual regulatory rules under consideration, I think it is important to note that potentially each of them--servicing requirements, capital requirements, and underwriting requirements--will affect the costs and liabilities associated with mortgage lending and thus the attractiveness of the mortgage lending business. The Federal Reserve is aware of this situation and will apply its best judgment to weigh the cost and availability of credit against consumer protection, investor clarity, and financial stability as it writes rules that are consistent with the statutory provisions that require those rules. But regardless of what the final contours of the rules are, I think the mortgage market will benefit from having them decided so that business models can be set and investments calibrated.

The Federal Reserve's quarterly Senior Loan Officer Opinion Survey on Bank Lending Practices (SLOOS) offers a more-nuanced view of how lending terms are changing. The SLOOS indicates that standards and terms in many loan categories have eased somewhat further in recent quarters from the very tight conditions that prevailed earlier in the recovery... SLOOS respondents suggested that stepped-up competition has induced a large number of domestic banks to reduce fees and spreads on C&I loans to firms of all sizes. The SLOOS also indicates that demand for many types of loans has continued to increase, with demand for C&I loans having risen to relatively high levels.

Consistent with the results of the SLOOS, C&I lending has indeed been rising sharply lately. Banks have focused on C&I lending because business borrowers' creditworthiness is improving and because the majority of C&I loans carry floating interest rates that reduce interest rate risk. In addition, domestic banks reportedly are picking up customers as a result of a pullback by some European institutions. Auto lending also has reportedly been solid, reflecting strong fundamentals in auto markets--such as robust demand for used cars and relatively low delinquency rates on existing auto loans. The strong fundamentals for auto loans in turn also appear to have contributed to an easing of lending standards and terms.

Almost by definition, prudential reforms are injunctions to firms or markets about what they should not do. Even affirmatively stated requirements to maintain specified capital ratios can be understood as prohibitions upon extending more credit, purchasing another instrument, or distributing a dividend unless the minimum ratio would be maintained. Prohibition and constraint are quite appropriately at the center of a regulatory system. Yet the policies that underlie regulation should embody a more affirmative set of social goals