I do believe that the enhancements that we've put in place to capital and liquidity requirements that are tailored by firm size and systemic importance have made an enormous difference to the safety and soundness of the U.S. financial system… I think this has been a very significant exercise and has resulted in far superior understanding by the firms themselves of the risks they face and improve management of those risks. Capital isn't sufficient to assure financial stability, often liquidity is what disappears in a financial crisis, and we've put in place, especially for the largest banking organizations, enhancements to liquidity through the liquidity coverage ratio and our proposed net stable funding ratio

I’ve mentioned this before, but when I first went to Treasury in 2006, Treasury Secretary Henry Paulson directed his staff (including me) to work with financial regulators to look for what might trigger the next crisis. We looked at a number of scenarios, including an individual large bank running into trouble or a hedge fund suffering large losses, among others. We didn’t consider a nationwide housing downturn. It seems so obvious now, but we didn’t see it, and we were looking. We should design our regulatory framework to assume that, as in 2008, regulators won’t have better insights than market participants. We must assume they won’t see a future crisis coming until it is too late.

Cleveland Fed President Loretta Mester, asked about her colleague Neel Kashkari's push at the Minneapolis Fed to possibly break up risky banks before they again imperil the economy, said his effort aims to bring more analysis to the lingering issue.

But the 2010 Dodd-Frank reforms have not yet been fully implemented and should be given some "time to work" before "going in a whole new direction," she said.

My view is that these [post-crisis] regulations are new, and we should be willing to adjust them as we learn. That said, we should also recognize that some reduction in market liquidity is a cost worth paying in helping to make the overall financial system significantly safer.

Mr. Kashkari is undeterred by the criticism. “The Wall Street critics and the lobbyists are reduced to trying to criticize the process or criticize my intentions because they can’t argue with me on the substance,” he said.

If a shock or event occurs, and banks prove to be not sufficiently resilient, it is critically important to proactively recapitalize the banking sector as quickly as possible while at the same time avoiding collateral damage from tighter credit standards. Put another way, with respect to the capital-to-assets ratio, it is vital to increase the capital (the numerator of the ratio) rather than allowing the adjustment to occur primarily through a reduction in assets, i.e. loans (the denominator).

The ultimate responsibility for risk identification and risk management remains with the supervised institution. The Federal Reserve’s role is to ensure that the institution has the necessary strong processes in place to achieve this objective. As risks emerge, supervisors intervene, within the realms of their safety and soundness mandates, to require that banks take corrective actions as necessary. Supervision can reduce the chance that a financial firm fails, but it can never provide a guarantee against failure.

Much of Mr. Kashkari’s remarks Tuesday were devoted to reiterating his commitment to addressing the too-big-to-fail problem that still surrounds the banking system. He said that “we need to be humble about our ability to forecast crises.” Because trouble often comes from unexpected places, it is that much more important to strengthen the resiliency of the financial system to deal with shocks, he said.

I believe we need to complete the important work that my colleagues are doing so that, at a minimum, we are as prepared as we can be to deal with an individual large bank failure. But given the enormous costs that would be associated with another financial crisis and the lack of certainty about whether these new tools would be effective in dealing with one, I believe we must seriously consider bolder, transformational options. Some other Federal Reserve policymakers have noted the potential benefits to considering more transformational measures.6 I believe we must begin this work now and give serious consideration to a range of options, including the following:

• Breaking up large banks into smaller, less connected, less important entities.
  
  
• Turning large banks into public utilities by forcing them to hold so much capital that they virtually can’t fail (with regulation akin to that of a nuclear power plant).
  
  
• Taxing leverage throughout the financial system to reduce systemic risks wherever they lie.

There are nonetheless three major sources of concern about potential weaknesses in the new framework for financial crisis management that has been introduced since the Great Financial Crisis. The first is its failure to resolve the problem of stigma--that is, the stigma of borrowing from the central bank at a time when the financial markets are on guard, looking for signs of weakness in individual financial institutions at a time of overall financial stress. Indeed, some of the Dodd-Frank Act reporting requirements may worsen the stigma problem.

The second is a concern that arises from the nature of financial and other crises. It is essential that we build strong frameworks to deal with potential crisis situations, and Dodd-Frank has done that. But these plans need to ensure that the authorities retain the capacity to deal with unanticipated events, for unanticipated events are inevitable. Retaining the needed flexibility may conflict with the desire to reduce moral hazard to a minimum. But, in simple language: Strengthening fire prevention regulations does not imply that the fire brigade should be disbanded.

Third, this concern is heightened by a related problem: The new system has not undergone its own stress test. That is, in one sense, fortunate, for the financial system will undergo its fundamental stress test only when we have to deal with the next potential financial crisis. That day will likely come later than it would have without Dodd-Frank and the excellent work done by regulators in the United States and around the world in strengthening financial institutions and the financial system. But it will come, and when it comes, we will need the flexibility required to deal with it.

Despite my assessment of current vulnerabilities, conditions can change quickly. And important blind spots in our view of the financial system remain, in part owing to data gaps. When it comes to financial stability, what you do not know really can hurt you--and there remains a good bit we do not know.

This lack of data can impede the design of regulation. There is a long history of data collection focused on banks, and supervisory data have contributed to our quantitative approach to regulation and supervision. For example, when we examine the likely implications of the failure of an institution's largest counterparty, we learn a great deal about the health of that institution and gain greater insight into its connections, through that counterparty, to other institutions.

But data on a range of activities--including securities lending, bilateral repos, and derivatives trading--that create funding and leverage risks remain inadequate and hence could prove destabilizing if sufficiently large or widespread. We gain some insight into these markets through our supervisory relationships with the largest bank holding companies, but the activities of important nonbank market participants, such as asset managers, and the interconnections across institutions remain more opaque.
...
While the steps to improve data taken so far will help, gaps will remain, especially with regard to unregulated or weakly regulated entities. These gaps impede both market participants' ability to discipline the risks taken by institutions and supervisors' ability to take prompt action. Nonetheless, I would also like to emphasize to this group of researchers that better data, by themselves, are only the start of the journey to better understanding.

Steve Liesman: I just have one question about all of this stuff Is it the policy of the Federal Reserve to force large banks to be smaller?

Dan Tarullo: It's not the policy to force them to be smaller. But I think it is the policy of our bank regulatory system as embodied in congressional legislation to make sure that large institutions of systemic importance do internalize the potential risks to the broader economy from their size and interconnectedness. So in essence, a firm has a choice which is that it can either maintain substantially higher capital levels or it can make a judgement that some forms of business or certain size of that business may not be worth the higher capital charge that takes account of those negative externalities. It really is up to the institution to make that evaluation but what we've tried to do it in a context that forces them to internalize costs.

[T]he liability side of the balance sheets of firms that are all "insurance companies" can vary substantially, just as with firms that are called "banks" or "bank holding companies." Yet capital regulation currently applicable to insurance companies seems not to make some of the relevant distinctions.

[The regulatory reforms that have taken place since the financial crisis] are well advanced and, in my view, have left the global systemically important banks far stronger than they were before the crisis. Together, they significantly reduce the probability of a large bank failure. But they would leave us short of meeting the overriding objective of eliminating the too-big-to-fail conundrum without a fourth reform--a viable resolution mechanism that could handle the failure of these institutions without severe damage to the economy. Until recently, no nation has had a way of handling such failures without that degree of damage.

We need to learn, but not overlearn, the lessons of the crisis. I believe there should be a high bar for "leaning against the credit cycle" in the absence of credible threats to the core or the reemergence of run-prone funding structures. In my view, the Fed and other prudential and market regulators should resist interfering with the role of markets in allocating capital to issuers and risk to investors unless the case for doing so is strong and the available tools can achieve the objective in a targeted manner and with a high degree of confidence.