The New York Fed and other supervisors are working with market participants to fundamentally change how CDS and other OTC derivatives are processed by applying increasingly stringent targets and performance standards. They are also emphasizing that dealers must demonstrate their capability to adequately manage the failure of a major counterparty, including calculating exposures rapidly, having clear management procedures, and conducting internal stress exercises. Finally, they are encouraging the development of well-regulated and prudently managed central counterparty clearing arrangements for CDS trades.

So how do we strengthen market discipline? Today's priority is clearly market stability. However, looking beyond the immediate turmoil, we need to design carefully and put in place a stronger capacity for resolution and crisis intervention that reinforces market discipline....

To address the perception that some institutions are too big to fail, we must improve the tools at our disposal for facilitating the orderly failure of a large complex financial institution. As former Federal Reserve Chairman Greenspan often noted, the real issue is not that an institution is too big or too interconnected to fail, but that it is too big or interconnected to liquidate quickly.

....

As I have continually noted, the financial landscape has changed, and non-bank financial institutions play a significantly greater role. We need to consider broadly the resolution regime in light of these changes. It is clear that some institutions, if they fail, can have a systemic impact, so we must give regulators the authorities to limit that impact and facilitate an orderly failure. In my view, looking beyond the immediate market challenges of today, we need to create a resolution process that ensures the financial system can withstand the failure of a large complex financial firm. To do this, we will need to give our regulators additional emergency authority to limit temporary disruptions. These authorities should be flexible and -- to reinforce market discipline -- the trigger for invoking such authority should be very high, such as a bankruptcy filing. And as part of this process we should consider ways to ensure that costs are imposed on creditors and equity holders. Any commitment of government support should be an extraordinary event that requires the engagement of the Executive Branch.

One of the central objectives in reforming our regulatory framework should be to mitigate the fragility of the system and to reduce the need for official intervention in the future. I know that many hope and believe that we could design our system so that supervisors would have the ability to act preemptively to diffuse pockets of risk and leverage. I do not believe that is a desirable or realistic ambition for policy. It would fail, and the attempt would entail a level of regulation and uncertainty about the rules of the game that would offset any possible benefit. I do believe, however, that we can make the system better able to handle failure by making the shock absorbers stronger.    

The objectives of regulatory policy should be to improve the capacity of the financial system to withstand the effects of failure and to reduce the overall vulnerability of the system to the type of funding runs and margin spirals we have seen in this crisis.
...
Inducing institutions to hold stronger cushions of capital and liquidity in periods of calm may be the best way to reduce the amplitude of financial shocks on the way up, and to contain the damage on the way down. Stronger initial cushions against stress reduces the need to hedge risk dynamically in a crisis, reducing the broader risk of a self-reinforcing, pro-cyclical margin spiral, such as we have seen in this crisis.

I think there are important questions on the table about the structure of regulatory authority and responsibility at the national (level).

But no matter how that comes out, I think the structure of the Federal Reserve system has served this country very well and in my view it ought to be preserved.

From comments to press, as reported by Reuters

At the Federal Reserve and at other bank regulatory agencies, our job is to reinforce the incentives and actions that are building a more resilient financial system. We need to make sure that regulatory minimum capital requirements and liquidity management plans protect reasonably well against shocks becoming systemic. Our supervisory guidance needs to be in place to prevent backsliding when, over the coming years, the memories and lessons of the current market turmoil fade, as they certainly will.

To these ends, we are reexamining a host of things ranging from Basel II to liquidity to transparency. Working with our domestic and international colleagues, we are looking to raise the Basel II capital requirements on specific exposures that have been troublesome, such as super senior CDOs of asset-backed securities and off-balance-sheet commitments. We are looking to the Basel Committee on Banking Supervision to update its guidance on liquidity management in light of the recent experience. And we and our supervisory colleagues are looking to require better disclosures of off-balance-sheet commitments and of valuations of complex structured products.

The process of implementing the PWG's [President's Working Group's] implementations will be challenging, in no small measure because of the continuing pressures of short-term crisis management. However, we do not have the luxury of waiting for markets to stabilize before we think about the future. Indeed, many of the necessary changes that have been identified, including increasing transparency, improving risk management, and attaining better coordination among regulators, could provide important support to the process of normalizing our financial markets.

Given its focus on fundamental reform, the recommendations of the Treasury blueprint are mostly intended to be undertaken in the longer term. In that respect, it is an important first step, and we look forward to working with the Congress and others in developing a framework that modernizes our financial and regulatory architecture. The analysis of the PWG [President's Working Group] that I will be discussing today is more sharply focused on recent events, and its recommendations are intended to be part of the near-term and medium-term effort to restore more normal functioning of financial markets and to improve the operation of the current system.

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.

In the mortgage area, the PWG [President's Working Group] recommended action at both the federal and state levels, including, for example, stronger nationwide licensing standards for mortgage brokers and more consistent government oversight for all originators. In particular, the PWG recommended that the Federal Reserve use its authority to strengthen consumer protection rules and enhance required disclosures for mortgage originations.

I strongly support this recommendation, and its implementation is well under way.

Separately, the GSEs--Fannie Mae and Freddie Mac--could be asked to do more. Recently, the Congress has greatly expanded Fannie Mae's and Freddie Mac's role in the mortgage market by temporarily increasing the conforming loan limits for these GSEs. In addition, their federal regulator, the Office of Federal Housing Enterprise Oversight, has lifted some of the constraints that were imposed on these entities because they have resolved some of their recent accounting and operational problems. Thus, now is an especially appropriate time to ask the GSEs to move quickly to raise more capital, which they will need to take advantage of these new securitization and investment opportunities, to provide assistance to the housing markets in times of stress, and to do so in a safe and sound manner. As the GSEs expand their roles in our mortgage market, there is a strong need for the Congress to move forward on GSE reform legislation, including the creation of a world-class GSE regulator.

In my view, there are a set of important objectives and principles that should guide this effort.

• We need to ensure there is a stronger set of shock absorbers, in terms of capital and liquidity, in those institutions, banks and a limited number of the largest investment banks, that are critical to market functioning and economic health, with a stronger form of consolidated supervision over those institutions.
• We need to substantially simplify and consolidate the regulatory framework, to reduce the opportunity for regulatory arbitrage, not just in the mortgage market, but more broadly.
• We need to make the financial infrastructure more robust, particularly in the derivatives and repo markets, so that the system can better withstand the effects of default by a major participant.
• We need to redesign the set of liquidity facilities that we maintain in normal times, and in extremis, in the United States and across other major central banks. And these changes will have to come with a stronger set of incentives and requirements for the management of liquidity risk by financial institutions with access to central bank liquidity.
• And we need to make sure that the Federal Reserve has the mix of authority and responsibility to respond with adequate speed and force to the prospects of systemic threats to financial stability.

Well, I would just make one comment, which is that one of the ideas in the blueprint is to give the Federal Reserve, sort of, broad authority to be a financial market stability regulator.  The Federal Reserve has a long tradition of trying to maintain financial stability and is very interested and concerned with those issues. But we would want to be sure that if we were given that very important responsibility that we had adequate powers, authorities, expertise and so on to make sure that we could do it effectively. And so that would be an issue for us to think about as we go forward.

From the Q&A session

Well, Congressman, first a word on the President's Working Group. That's an informal group of the heads of various agencies. It has no separate statutory authorities, but it's a chance to get together and talk about issues.  And on a number of occasions, as you've noted, we've put out reports that have no statutory authority but represent our thinking and our staff's thinking on some various issues.

I agree with those critics who argue that there was something fundamentally unfair about the disparity in treatment between the few large financial institutions that were saved versus the millions of individuals who lost their homes or their jobs. My response is not particularly satisfying. Recessions inflict considerable pain on innocent bystanders in the economy. Depressions greatly compound this pain. Given the Federal Reserve’s role and authority, what we knew at the time and the powers and tools that were available to us, I think we made good choices. If the large systemic banking organizations had failed, the hardships inflicted on households and small business would have been far worse.

From my perspective, I believe that any critique of the Fed or other agencies should be focused more on the regulatory and supervisory shortcomings—some of which, I admit, were ours—that created the economic and financial market circumstances in which the Fed’s extraordinary interventions proved necessary.