There are those who believe we have made great strides with Dodd-Frank and if we implement it well, all will be fine. Some believe that that the industry is over-regulated, which may be true, but we should not confuse over-regulated with well-regulated. And some of us are certain that in spite of all that’s been done and debated, the soundness of the largest financial institutions and the systemic risks they continue to pose is no better. In my view, it is even worse than before the crisis. As well-intentioned as the Dodd-Frank Act may be, it will not improve outcomes.

The differences in the business models of systemically important financial firms and community banks are obvious.  Yet the financial crisis and ensuing recession have revealed deficiencies in risk management in institutions of both types.  Changes in competitive environments require banks to respond with changes in their business strategies.  But the financial crisis has also revealed the importance of banks adopting risk-management strategies appropriate to these strategic changes, and of bank regulatory agencies adapting their supervisory models to both these kinds of changes in financial institutions.

The bottom line of our analysis is that creditors of large, complex financial institutions expected protection if failure threatened. As a consequence, they had little incentive to be concerned about the condition and prospects of such institutions, leading to underpricing of risk-taking. With risk underpriced, large institutions took on excessive amounts of it, leading eventually to the precarious position of some of them. And policymakers, fearing massive, negative spillover effects to other institutions, financial markets more generally, and the economy itself, validated creditor expectations by providing protection.

The Federal Reserve has been involved in a number of exercises to understand and document the risk-management lapses and shortcomings at major financial institutions, including those undertaken by the Senior Supervisors Group, the President's Working Group on Financial Markets, and the multinational Financial Stability Forum.¹

Based on the results of these and other efforts, the Federal Reserve is taking steps to improve regulatory requirements and risk management at regulated institutions.  Our actions have covered liquidity risk management, capital planning and capital adequacy, firm-wide risk identification, residential lending, counterparty credit exposures, and commercial real estate.  Liquidity and capital have been given special attention. 

(T)he ongoing fundamental transformation in financial services offers great potential opportunities for those institutions able to integrate strategy and risk management successfully, and I will argue that survival will hinge upon such an integration in what I will call a "strategic risk management framework."

...

Over the past year there have been a number of studies analyzing the causes of the current turmoil, which include shortcomings in the risk management practices of financial institutions.² It is absolutely clear that many financial institutions need to undertake a fundamental review of risk management. They now realize that ignoring risk management in any aspect of the banking business usually creates problems later on. Risk management shortcomings need to be addressed not only to improve the health and viability of individual institutions, but also to maintain stability for the financial system as a whole.

Extreme losses have occurred much more frequently than we would have assumed four or five years ago ... When we were
first seeing billion dollar losses, people would say those are thousand year events ... but we need to think more about them now.

From Q&A as reported by Market News International

If I were to select a light-hearted title for my remarks, it might be “Fear and Loathing on Wall Street.” The basic premise is that as firms have become increasingly concerned about the valuation (pricing) of certain assets, their ability to accurately assess counterparty risk and the liquidity position of counterparties has become clouded. The lack of transparency in the prices of underlying assets, and the significant losses of some financial firms whose deteriorating situation had not been evident in earlier financial statements, have together made investors skittish. As a result, financial firms are increasingly willing to pass up the use of other attractive financing opportunities if they believe that action might lead to speculation about the liquidity or financial strength of their firm.

While such skittishness is not unusual during periods of illiquidity, it is unusual for a period of illiquidity to last this long.

The volume of term lending transactions has declined significantly, with few buyers or sellers of term funds. I can suggest several reasons.

First, many potential suppliers of funds have become increasingly concerned about their capital position, causing them to look for opportunities to shrink (or slow the growth of) assets on their balance sheets, in order to maintain a desirable capital-to-assets ratio. Since unsecured inter-bank lending provides relatively low returns and has little benefit in terms of relationships, banks may prefer to use their balance sheet to fund higher-returning assets that advance long-term customer relationships.

Second, as the uncertainty over asset valuations has increased, banks have become reluctant to take on significant counterparty risk to financial institutions – particularly with those that have significant exposure to complex financial instruments.

Third, many potential borrowers are reluctant to buy term funds at much higher rates than can be obtained overnight, for fear that they may signal to competitors that they have liquidity concerns. However, when the counterparty is a central bank, financial institutions have been quite willing to buy term funding, sometimes at rates higher than they would expect if they were to borrow funds overnight.

I believe it is fair to say that the creation of new, innovative financial products outstripped banks' risk-management capabilities. As I noted earlier, some banks that chose to hold super senior CDO securities did so because they trusted in an external triple-A credit rating. Because some banks did not fully understand all aspects of these exposures, once the risks crystallized last year in a weak house price environment, compounded by widespread liquidity pressures in many markets, banks had to scramble to measure and hedge these risks.

Liquidity risk is a familiar risk to banks, but it has appeared in somewhat new forms recently. While the originate-to-distribute model aims to move exposures off of banks' balance sheets, the risk remains that a sudden closing of securitization markets can force a bank to hold and fund exposures that it had originated with the intent to distribute. ...

Concentration risk is another familiar risk that is appearing in a new form. Banks have always had to worry about lending too much to one borrower, one industry, or one geographic region. But as smaller banks hold more of their balance sheet in types of loans that are difficult to securitize, concentration risks can develop. Concentrations of commercial real estate exposures are currently quite high at some smaller banks. This has the potential to make the banking sector much more sensitive to a downturn in the commercial real estate market.

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.
...
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 supervisors concluded that the firms that suffered the most significant losses tended to exhibit common problems, including insufficiently close monitoring of off-balance-sheet exposures, inadequate attention to the implications for the firm as a whole of risks taken in individual business lines, dependence on a narrow range of risk measures, deficiencies in liquidity planning, and inadequate attention to valuation issues. To be sure, firms varied in the degree to which they were subject to these weaknesses, with better performance on these dimensions generally being reflected in better financial performance.

Correcting these weaknesses is, first and foremost, the responsibility of the firms' managements and they have powerful incentives to do so. But prudential supervisors, including the Federal Reserve, must also review their existing policies and guidance to identify areas where changes could help firms strengthen their risk management--a process that is already under way.

I think it is naive to think that creditors will view their investments in the largest financial institutions as truly at risk. Consequently, I do not think that increased market discipline is likely to be the panacea that some believe.

In terms of the financial cushions, the challenge is to sustain a level of capital and liquidity that is large enough to withstand a more adverse financial and economic environment than we have experience recently. Here the job of the risk management discipline is to try to compensate for failure of imagination, to counteract the gravitational effect on measured exposure produced by recent history, and to try to anticipate the adverse effects on market liquidity that may come with a shock. This requires a healthy skepticism about models, discipline and care in the face of competitive pressures, and humility about what we can know about the future.

The dramatic changes we’ve seen in the structure of financial markets over the past decade and more seem likely to have reduced this vulnerability {to financial crashes}. The larger global financial institutions are generally stronger in terms of capital relative to risk. Technology and innovation in financial instruments have made it easier for institutions to manage risk. Risk is less concentrated in the banking system, where moral hazard concerns and other classic market failures are more likely to be an issue, and spread more broadly across a greater diversity of institutions.

And yet this overall judgment, that both financial efficiency and stability have improved, requires some qualification. Writing a decade ago about the history of the financial shocks of the 1980s and early 1990s, Jerry Corrigan argued that these same changes in financial markets we see today, though less pronounced then than now, created the possibility that financial shocks would be less frequent, but in some contexts they could be more damaging. This judgment, that systemic financial crises are less probable, but in the event they occur could be harder to manage, should be the principal preoccupation of market participants and policymakers today.

What factors might contribute to this risk, a risk that could be described as the possibility of longer, fatter tails? One reason is a consequence of consolidation...  Another reason is the consequence of leverage...  A third reason is the consequence of long periods of low losses and low volatility.