While regulatory reform proposals are already beginning to surface, I see value in first evaluating the principles that should frame the discussion.  Before we begin to work on regulatory details we need to evaluate whether the problem was poor execution of a well-considered regulatory framework, or that important principles were absent from the framework.  While in my view the recent experience shows elements of both, I want to focus today on regulatory principles rather than their implementation.

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Our regulatory framework clearly needs to be reconsidered, in light of recent events.  Both in the U.S. and globally, we had in place a complex set of regulations and supervisory structures intended, in part, to increase the likelihood that financial intermediaries would remain well capitalized without government assistance.  Like the risk models, bank regulators did not foresee the dramatic illiquidity that could emerge during a period of acute financial turmoil – nor the changes in the value of assets on balance sheets, or the degree of correlation of those asset values.

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The current crisis provides the opportunity and impetus to reexamine a regulatory framework that originated in the Great Depression.  While I believe there is a clear need to redesign the current regulatory structure, it is important that we not lose important features of the current market.  It is critical that any regulatory design not stifle the industry’s innovation and creativity.  However, the regulatory structure needs to be more adaptable to innovations – in order to ensure that new safety and soundness, and systemic, concerns are not ignored.  And it needs to be aware of the details of the evolving financial-market structure.

Additional regulations do run the risk of moral hazard where the presence of a safety net creates an incentive to take additional risk.  While any countercyclical monetary, fiscal, or regulatory policy runs this risk, it should be minimized.  Ideally, situations requiring public support should occur only after losses have been borne by equity holders, and existing management and directors have been held responsible for the losses.

To the extent a new regulatory structure reduces counterparty risk, or requires offsets in capital for transactions involving significant counterparty risk, the likelihood of spillover effects from one firm’s failure should be significantly reduced.  Ideally a new structure will reduce the likelihood of future financial turmoil of the length and severity of current financial problems.

In times of widespread distress, many counterparties may have to sell assets simultaneously to post margin.  This occurrence can potentially lead to a situation in the market in which assets are sold quickly and below their fundamental values.  When many counterparties are forced to liquidate similar assets, prices for those assets are pushed down.  If these assets are used as collateral on other positions, then the decline in value leads to additional margin calls.  This set of circumstances, in turn, forces further liquidation and price declines.  A widespread use of rating triggers can accelerate this downward slide, with further losses in asset values triggering additional downgrades and requirements to post collateral and liquidate positions.  Recent events have demonstrated this potentially destabilizing dynamic at work.

The critical policy question of our time is where to establish the boundaries around the public-sector safety net provided to financial market participants, now that the old boundaries are gone. In doing so, the prime directive should be that the extent of regulatory and supervisory oversight should be commensurate with the extent of access to central bank credit in order to contain moral hazard effectively.

Note that it will not be sufficient simply to roll back the current lending programs when the economy recovers. The precedents that have been set during this episode will influence how market participants expect policymakers to react during the next episode of financial market turmoil. Establishing a coherent and stable financial regulatory regime will require rolling back expectations about how the policymakers will respond to the next financial market disturbance. Rolling back those expectations will be impossible if moral hazard concerns are always set aside in the exigencies of a crisis.⁴

Because of the financial crisis and the response by the Treasury and the Fed, the financial services industry is restructuring. When some normality returns to the markets — which eventually it surely will — some type of regulatory reform will be needed.

Some people may think that expanding the Federal Reserve's regulatory and supervisory authority would prevent the types of financial crises we have been experiencing this year. Yet, I believe it is important to be realistic about recognizing the limits of what a central bank can and should do. A modern financial system will never be immune to all financial stress. Setting up expectations that the Fed will surely be unable to fulfill would undermine our ability to achieve our primary monetary policy and financial stability objectives.

The exact outcome of this regulatory reform is unknown at this point. However, as we work on this reform, I believe we must strive to develop sound policies that obey the four principles I have discussed today — clear and feasible objectives; a commitment to systematic policies; transparency; and a healthy respect for the independence of the central bank.

(J)ust from my personal perspective, I’ll consider us to be back to normal when the Federal Reserve returns to the back pages of the paper’s business section... But we are not there quite yet. And even when markets return to what is typically thought of as “normal,” changes will still be needed for the long term. We need to focus on the factors I cited as causes of the turmoil—lax underwriting standards, complex financial products, and excessive leverage.

History tells us that financial crises invariably lead governments to adopt regulatory reforms intended to prevent similar crises in the future. Moreover, without careful analysis of the crisis, hasty reform may fail to address the problem and could impose unneeded and burdensome regulation. In general, I would argue against making major policy reforms in the "heat of battle" because doing so risks adopting policies that have unintended consequences. Such "quick fixes" may inadvertently hamper market competition or innovation and create conditions that may provide the foundation of the next crisis.

Developing an effective securitization model is not easy--according to one economic historian, mortgage securitization schemes were tried and abandoned at least six times between 1870 and 1940.¹  Eventually, experience provided three principles for successful mortgage securitization.  First, for the ultimate investors to be willing to acquire and trade mortgage-backed securities, they must be persuaded that the credit quality of the underlying mortgages is high and that the origination-to-distribution process is managed so that originators, such as mortgage brokers and bankers, have an incentive to undertake careful underwriting.  Second, because the pools of assets underlying mortgage-backed securities have highly correlated risks, including interest rate, prepayment, and credit risks, the institutions and other investors that hold these securities must have the capacity to manage their risks carefully.  Finally, because mortgage-backed securities are complex amalgamations of underlying mortgages that may themselves be complex to price, transparency about both the underlying assets and the mortgage-backed security itself is essential.

Making progress against the turmoil at hand is certainly the top priority at this stage. But soon enough policymakers will want to identify fundamental reforms that reduce the likelihood that we will face another period of financial instability.

[F]or a market economy to work best, it must to the maximum extent possible find a balance between financial stability and a stable price environment and in doing so must be able to allow individual institutions to fail.  The "Too Big to Fail" issue will only grow in importance as the consolidation of the financial industry grows in both size and scope in future decades.

An effective means of increasing the resilience of the financial system is to strengthen its infrastructure. For my purposes today, I want to construe "financial infrastructure" very broadly, to include not only the "hardware" components of that infrastructure--the physical systems on which market participants rely for the quick and accurate execution, clearing, and settlement of transactions--but also the associated "software," including the statutory, regulatory, and contractual frameworks and the business practices that govern the actions and obligations of market participants on both sides of each transaction.

I do not have the time today to do justice to the question of the procyclicality of, say, capital regulations and accounting rules. This topic has received a great deal of attention elsewhere and has also engaged the attention of regulators; in particular, the framers of the Basel II capital accord have made significant efforts to measure regulatory capital needs "through the cycle" to mitigate procyclicality. However, as we consider ways to strengthen the system for the future in light of what we have learned over the past year, we should critically examine capital regulations, provisioning policies, and other rules applied to financial institutions to determine whether, collectively, they increase the procyclicality of credit extension beyond the point that is best for the system as a whole.

{In reference to separating the Fed from other institutions by adding responsibilities} I think it's likely to emerge as a theme. I think it ought to be front and center in the discussion about financial regulatory reform and restructuring if Congress would like to go down that path, restructuring regulatory responsibilities at the federal level. Our paramount responsibility is keeping prices stable, inflation low and steady. There are other responsibilities we have accumulated over the years. And we have, as a result of our history, where we came from, and various responsibilities that have been given to us. But our ability to exercise independent judgment about the level of the policy rate, I think, is quite important. And I do see some merit to the argument that adding responsibilities can threaten to dilute the independence that we need for that responsibility.

I believe the most important imperative is to build a financial system that is more robust to very bad outcomes and more resilient to shocks. This means (1) a system in which the major institutions are less vulnerable to shocks; (2) a system that is less vulnerable to margin spirals and a generalized pull-back in liquidity and funding; and (3) a system that is more able to withstand the effects of failure of a major financial institution.

As I have noted, I believe that the Federal Reserve's actions to facilitate the acquisition of Bear Stearns, thereby preventing its bankruptcy and the disorderly liquidation of positions by its counterparties and creditors, were necessary and warranted to head off serious damage to the U.S. financial system and our economy. That said, the intended purpose of Federal Reserve lending is to provide liquidity to sound institutions. We used our lending powers to facilitate an acquisition of a failing institution only because no other tools were available to the Federal Reserve or any other government body for ensuring an orderly liquidation in a fragile market environment. As part of its review of how best to increase financial stability, and as has been suggested by Secretary Paulson, the Congress may wish to consider whether new tools are needed for ensuring an orderly liquidation of a systemically important securities firm that is on the verge of bankruptcy, together with a more formal process for deciding when to use those tools. Because the resolution of a failing securities firm might have fiscal implications, it would be appropriate for the Treasury to take a leading role in any such process, in consultation with the firm's regulator and other authorities.