Let me be clear that I do not think that we should rely on regulation, by itself, either at the micro- or macro-level, to prevent future crises. Markets can provide very effective discipline on the decisions of financial market participants. Any new regulatory framework should be designed to work with, and not supplant, market forces.

I propose a framework that I will call “tiered parity.” In this framework, I would construct a small number of tiers and assign each financial company to one of the tiers based on the complexity of its operations and the degree of risk it poses to the financial system. For example, a three-tiered framework could have categories labeled “noncomplex,” “moderately complex,” and “systemically important,” with corresponding degrees of regulatory requirements and supervisory oversight. Where an institution is placed could depend on the situation at hand. Some hedge funds, for example, might deserve closer scrutiny during an asset boom or commodities squeeze, but less oversight during normal times.

My key concern in considering the Fed's future role in ensuring financial stability involves my fourth principle: how to ensure the Fed's independence to conduct monetary policy. I have already argued that the Fed should not have responsibility for funding or managing the resolution mechanism for failing institutions. Nor should its lending policies stray into the realm of allocating credit across firms or sectors of the economy. The perception that the Federal Reserve is in the business of allocating credit is sure to generate pressure on the Fed from all sorts of interest groups. In my view, if government must intervene in allocating credit, doing so should be the responsibility of the fiscal authority rather than the central bank.

[A] reasonable resolution regime for nonbank financial institutions could easily be modeled on the FDIC's bridge-bank approach. Such a resolution procedure should address some of the shortcomings of existing bankruptcy law, which seeks to maximize the payoffs to the firm's creditors and makes no provisions for systemic considerations. We need a resolution mechanism that explicitly addresses ways to reduce financial disruptions and minimize the costs to taxpayers. As in the FDIC's bridge-bank authority, uninsured creditors could receive expedited payoffs based on historical recoveries, generally less than 100 percent, while shareholders of the failed institution would be wiped out.

Going forward, we will need changes in the capital regime as the financial environment returns closer to normal conditions.  Working with other domestic and foreign supervisors, we must strengthen the existing capital rules to achieve a higher level and quality of required capital.  Institutions should also have to establish strong capital buffers above current regulatory minimums in good times, so that they can weather financial market stress and continue to meet customer credit needs.  This is but one of a number of important ways in which the current procyclical features of financial regulation should be modified, with the aim of counteracting rather than exacerbating the effects of financial stress.

Developing appropriate resolution procedures for potentially systemic financial firms, including bank holding companies, is a complex and challenging task that will take some time to complete.  We can begin, however, by learning from other models, including the process currently in place under the Federal Deposit Insurance Act (FDIA) for dealing with failing insured depository institutions and the framework established for Fannie Mae and Freddie Mac under the Housing and Economic Recovery Act of 2008.  Both models allow a government agency to take control of a failing institution's operations and management, act as conservator or receiver for the institution, and establish a "bridge" institution to facilitate an orderly sale or liquidation of the firm.  The authority to "bridge" a failing institution through a receivership to a new entity reduces the potential for market disruption, limits the value-destruction impact of a failure, and--when accompanied by haircuts on creditors and shareholders--mitigates the adverse impact of government intervention on market discipline.

We need more transparency and homogeneity in securities. The difficulty in valuing opaque and heterogeneous securities has led to greater illiquidity, price volatility and market risk, bigger haircuts and more forced deleveraging. Opacity has also led to an undue reliance on credit ratings.

Self-regulation is to regulation as self-importance is to importance.

As reported by the Financial Times

Editor's note:  similar sentiments are expressed here

To mitigate these risks, we must find a credible way to resolve these uncertainties and eliminate the need for ad hoc rescues by government agencies and the Fed in particular. One wrong-headed approach would be to erect a battery of new regulatory restrictions in an attempt to drive the probability of failure to zero. Such an approach would generate large supervisory costs, stifle innovation, and result in regulatory arbitrage as markets work to evade the regulations. This type of arbitrage was a contributor to the current financial crisis.

I think there is a compelling argument for some form of action to address procyclicality through policy change.  Whether that policy change should be addressed through accounting or regulatory rules is open to debate.

With the economy likely to shrink significantly in the first half of this year, the unemployment rate rising higher than 8.5 percent is, unfortunately, very likely.
...
I believe that below-potential growth is likely to persist until financial markets and financial institutions can resume more normal functioning.  So in addition to the other steps being taken to stimulate the economy, we need to be sure that actions to support the stability of the financial system are taken without delay – and, in the slightly longer term, that regulatory frameworks are thoughtfully reformed.

{The G-30} Report implicitly assumes that, while regulated banking institutions will be dominant providers of financial services, a variety of capital market institutions will remain active. Organized markets and private pools of capital will be engaging in trading, transformation of credit instruments, and developing derivatives and hedging strategies, and other innovative activities, potentially adding to market efficiency and flexibility.

These institutions do not directly serve the general public and individually are less likely to be of systemic significance. Nonetheless, experience strongly points to the need for greater transparency. Specifically beyond some minimum size, registration of hedge and equity funds, should be required, and if substantial use of borrowed funds takes place, an appropriate regulator should be able to require periodic reporting and appropriate disclosure.

Furthermore, in those exceptional cases when size, leverage, or other characteristics pose potential systemic concerns, the regulator should be able to establish appropriate standards for capital, liquidity and risk management.

History clearly shows, and recent experience confirms, that--because of the dependence of modern economies on the flow of credit--serious financial instability imposes disproportionately large costs on the broader economy.  The rationale for public investment in the financial industry is not, therefore, any special regard for managers, workers, or investors in that industry over others, but rather the need to prevent a further deterioration in financial conditions that would destroy jobs and incomes in all industries and regions. That said, the public is entitled to demand that policymakers take near-term, concrete actions to ensure that we do not face a similar crisis in the future.  An important part of those actions should be to create a stronger supervisory and regulatory system in which gaps and unnecessary duplication in coverage are eliminated, lines of supervisory authority and responsibility are clear, and oversight powers are sufficient to curb excessive leverage and risk-taking, particularly in systemically critical institutions.  The Federal Reserve stands ready to work closely with the Congress to achieve meaningful and effective regulatory reform.

"It's very important for us to put out the fire first and then think about the fire code. Going forward we have to look at the code of regulation for the financial system."

From the Q&A session, as reported by the Telegraph

Confronted with a barrage of criticism from lawmakers, former officials and even some of his staff, Cox said he took pride in his measured response to the market turmoil.

"What we have done in this current turmoil is stay calm, which has been our greatest contribution -- not being impulsive, not changing the rules willy-nilly, but going through a very professional and orderly process that takes into account unintended consequences and gives ample notice to market participants," Cox said. This caution, he added, "has really been a signal achievement for the SEC."

Taking a swipe at the shifting response of the Treasury and Fed in addressing the financial crisis, he said: "When these gale-force winds hit our markets, there were panicked cries to change any and every rule of the marketplace: 'Let's try this. Let's try that.' What was needed was a steady hand."

Cox said the biggest mistake of his tenure was agreeing in September to an extraordinary three-week ban on short selling of financial company stocks. But in publicly acknowledging for the first time that this ban was not productive, Cox said he had been under intense pressure from Treasury Secretary Henry M. Paulson Jr. and Fed Chairman Ben S. Bernanke to take this action and did so reluctantly. They "were of the view that if we did not act and act at that instant, these financial institutions could fail as a result and there would be nothing left to save," Cox said.

As reported by the Washington Post.