[T]here is a perception that FICC markets and their participants are highly sophisticated and do not need protection. While that may be generally true, the perspective is too narrow, because the importance of these markets extends far beyond the largest participants in them. The market mechanism allocates credit and determines the borrowing costs of households, companies and governments. Proper market functioning is really a public good that relies on confidence and trust among market participants and the public. Bad conduct, weak internal firm governance, misaligned incentives, and flawed market structure can all place this trust at risk.
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The Dodd-Frank Act also imposed rules requiring greater transparency in over-the-counter derivatives markets through the use of central clearing, trade repositories, and swap execution facilities. Given the issues around OTC derivatives during the recent crisis, these clearly are important initiatives. But despite significant progress, there are still a number of impediments to sharing trade report data across regulatory agencies and jurisdictions, leaving us with only a piecemeal picture of the overall market rather than the full transparency that we desire.
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With surveillance and penalties in place, and a new administrator, one might be excused for thinking that there is nothing more to be done {about LIBOR}. In fact, some people do think that. That is emphatically not the view of the FSB Official Sector Steering Group that I now co-chair with Martin, which concluded that it is essential to develop one or more risk free (or near risk free) alternatives to LIBOR for use in financial contracts such as interest rate derivatives. The reasons are related to the structure of both LIBOR and the market that underlies it. Unsecured interbank borrowing has been in a secular decline for some time, and there is a scarcity, or outright absence in longer tenors, of actual transactions that banks can use to estimate their daily submission to LIBOR or that can be used by others to verify those submissions. LIBOR is huge--there are roughly $300 trillion in gross notional contracts that reference it--so the incentives to manipulate it still remain in place. And the structural problems go much further than the incentives for manipulation. Markets need to be fair, effective, and also safe. If the publication of LIBOR were to become untenable because the number of transactions that underlie it declined further, then untangling the outstanding LIBOR contracts would entail a legal mess that could endanger our financial stability.

For these reasons, the Federal Reserve has convened a group of the largest global dealers to form the Alternative Reference Rates Committee. We have asked them to work with us in promoting alternatives to U.S. dollar LIBOR that better reflect the current structure of funding markets. As the Review's consultation document notes, issues of this kind are really global in nature; U.S. dollar LIBOR contracts are traded throughout the world, not simply in the United States. For this reason we are working in close consultation with our foreign regulatory counterparts in this endeavor.

One guiding principle we should follow in any regulation is to pay attention to the incentives created by the regulatory system we have put into place. Explicit and implicit rules and the ways they are implemented create incentives. These incentives influence the behavior of all market participants: the financial intermediaries and their investors and customers, and the regulators. A second principle to follow in regulation is to avoid working against market forces. Instead, we should design a system that harnesses market discipline to work with improved regulation. I view Dodd-Franks establishment of the OFR to collect financial firm data, as well the acts permission to compel more public disclosures, as encouraging the transparency needed for market discipline.

So we have finalized our Basel III capital requirements that significantly increase the quality and quantity of capital in the banking system. Even before we did that, through our stress tests we have worked to ensure that especially the largest and most systemic institutions have the ability to not only survive a very adverse stress to the system but also to lend and support the needs of the economy through such a stress. The amount of capital in the banking system has basically doubled since 2009.

With respect to bubbles, I've stated my strong preferences to use macroprudential and supervision policies to address areas where we see concerns. And as I mentioned, we're doing that in the case of, for example, leveraged lending. But I would never take off the table totally the idea that monetary policy might be needed to address financial stability concerns. To me, now I don't see financial stability concerns at the level at this point where they need to be a key determinant of monetary policy. And it's not my preference as a first line of defense by any means. But I would never want to take off the table that in some circumstances, particularly if macroprudential tools failed, monetary policy might be called on to play a role. But we're not there.

Several financial sector reform programs were prepared within a few months after the Lehman Brothers failure. These programs were supported by national policymakers, including the community of bank supervisors. The programs--national and international--covered some or all of the following nine areas:

(1) to strengthen the stability and robustness of financial firms, "with particular emphasis on standards for governance, risk management, capital and liquidity"
(2) to strengthen the quality and effectiveness of prudential regulation and supervision;
(3) to build the capacity for undertaking effective macroprudential regulation and supervision;
(4) to develop suitable resolution regimes for financial institutions;
(5) to strengthen the infrastructure of financial markets, including markets for derivative transactions;
(6) to improve compensation practices in financial institutions;
(7) to strengthen international coordination of regulation and supervision, particularly with regard to the regulation and resolution of global systemically important financial institutions, later known as G-SIFIs;
(8) to find appropriate ways of dealing with the shadow banking system; and
(9) to improve the performance of credit rating agencies, which were deeply involved in the collapse of markets for collateralized and securitized lending instruments, especially those based on mortgage finance.

There are many models of regulatory coordination, but I shall focus on only two: the British and the American. As is well known, the United Kingdom has reformed financial sector regulation and supervision by setting up a Financial Policy Committee (FPC), located in the Bank of England; the major reforms in the United States were introduced through the Dodd-Frank Act, which set up a coordinating committee among the major regulators, the Financial Stability Oversight Council (FSOC).

In discussing these two approaches, I draw on a recent speech by the person best able to speak about the two systems from close-up, Don Kohn. Kohn sets out the following requirements for successful macroprudential supervision: to be able to identify risks to financial stability, to be willing and able to act on these risks in a timely fashion, to be able to interact productively with the microprudential and monetary policy authorities, and to weigh the costs and benefits of proposed actions appropriately. Kohn's cautiously stated bottom line is that the FPC is well structured to meet these requirements, and that the FSOC is not. In particular, the FPC has the legal power to impose policy changes on regulators, and the FSOC does not, for it is mostly a coordinating body.

After reviewing the structure of the FSOC, Kohn presents a series of suggestions to strengthen its powers and its independence. The first is that every regulatory institution represented in the FSOC should have the goal of financial stability added to its mandate. His final suggestion is, "Give the more independent FSOC tools it can use more expeditiously to address systemic risks." He does not go so far as to suggest the FSOC be empowered to instruct regulators to implement measures somehow decided upon by the FSOC, but he does want to extend its ability to make recommendations on a regular basis, perhaps on an expedited "comply-or-explain" basis.

It could be that large banks can finance themselves more cheaply because they are more efficient, that is, that there are economies of scale in banking. For some time, the received wisdom was that there was no evidence of such economies beyond relatively modest-sized banks, with balance sheets of approximately $100 billion. More recently, several papers have found that economies of scale may continue beyond that level. For example, the title of a paper by Joseph Hughes and Loretta Mester, "Who Said Large Banks Don't Experience Scale Economies? Evidence from a Risk-Return Driven Cost Function" suggests that large institutions may be better able to manage risk more efficiently because of "technological advantages, such as diversification and the spreading of information...and other costs that do not increase proportionately with size." That said, these authors conclude that "[W]e do not know if the benefits of large size outweigh the potential costs in terms of systemic risk that large scale may impose on the financial system." They add that their results suggest that "strict size limits to control such costs will likely not be effective, since they work against market forces..."

The TBTF theory of why large banks are a problem has to contend with the history of the Canadian and Australian banking systems. Both these systems have several very large banks, but both systems have been very stable--in the Canadian case, for 150 years. Beck, Demirguc-Kunt, and Levine (2003) examined the impact of bank concentration, bank regulation, and national institutions on the likelihood of a country suffering a financial crisis and concluded that countries are less likely to suffer a financial crisis if they have (1) a more concentrated banking system, (2) fewer entry barriers and activity restrictions on bank activity, and (3) better-developed institutions that encourage competition throughout the economy.32 The combination of the first finding with the other two appears paradoxical, but the key barrier to competition that was absent in Canada was the prohibition of nationwide branch banking, a factor emphasized by Calomiris and Haber in their discussion of the Canadian case. In addition, I put serious weight on another explanation offered in private conversation by a veteran of the international central banking community, "Those Canadian banks aren't very adventurous," which I take to be a compliment.

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Why is the TBTF phenomenon so central to the debate on reform of the financial system? It cannot be because financial institutions never fail. Some do, for example, Lehman Brothers and the Washington Mutual failed in the Great Recession

Almost certainly, TBTF is central to the debate about financial crises because financial crises are so destructive of the real economy. It is also because the amounts of money involved when the central bank or the government intervenes in a financial crisis are extremely large Another factor may be that the departing heads of some banks that failed or needed massive government assistance to survive nonetheless received very large retirement packages.

One can regard the entire regulatory reform program, which aims to strengthen the resilience of banks and the banking system to shocks, as dealing with the TBTF problem by reducing the probability that any bank will get into trouble. There are, however, some aspects of the financial reform program that deal specifically with large banks. The most important such measure is the work on resolution mechanisms for SIFIs, including the very difficult case of G-SIFIs. In the United States, the Dodd-Frank Act has provided the FDIC with the Orderly Liquidation Authority (OLA)--a regime to conduct an orderly resolution of a financial firm if the bankruptcy of the firm would threaten financial stability. And the FDIC's single-point-of-entry approach for effecting a resolution under the new regime is a sensible proposed implementation path for the OLA.

Closely associated with the work on resolution mechanisms is the living will exercise for SIFIs. In addition, there are the proposed G-SIB capital surcharges and macro stress tests applied to the largest BHCs ($50 billion or more). Countercyclical capital requirements are also likely to be applied primarily to large banks. Similarly the Volcker rule, or the Vickers rules in the United Kingdom or the Liikanen rules in the euro zone, which seek to limit the scope of a bank's activities, are directed at TBTF, and I believe appropriately so.

What about simply breaking up the largest financial institutions? Well, there is no "simply" in this area. At the analytical level, there is the question of what the optimal structure of the financial sector should be. Would a financial system that consisted of a large number of medium-sized and small firms be more stable and more efficient than one with a smaller number of very large firms? That depends on whether there are economies of scale in the financial sector and up to what size of firm they apply--that is to say it depends in part on why there is a financing premium for large firms. If it is economies of scale, the market premium for large firms may be sending the right signals with respect to size. If it is the existence of TBTF, that is not an optimal market incentive, but rather a distortion

Would breaking up the largest banks end the need for future bailouts? That is not clear, for Lehman Brothers, although a large financial institution, was not one of the giants--except that it was connected with a very large number of other banks and financial institutions. Similarly, the savings and loan crisis of the 1980s and 1990s was not a TBTF crisis but rather a failure involving many small firms that were behaving unwisely, and in some cases illegally. This case is consistent with the phrase, "too many to fail." Financial panics can be caused by herding and by contagion, as well as by big banks getting into trouble.

In short, actively breaking up the largest banks would be a very complex task, with uncertain payoff.

The special regulatory aims for such institutions should reflect this systemic focus. The very large negative externalities associated with such failures could be realized through a classic domino effect or through contagion effects. As the financial crisis showed, losses in a tail event are likely to be correlated for large firms deeply engaged in trading, structured products, and other capital market instruments, and relying on similar sources of short-term funding. Thus, the regulatory framework should aim to reduce the chances of distress or failure at such firms to a greater extent than traditional, microprudential regulation would. Moreover, it should explicitly take into account the correlations and inter-dependencies in asset holdings and funding…

At the other end of the spectrum are community banks, conventionally defined as those with less than $10 billion in assets… While these banks will suffer the fallout from systemic problems, they are unlikely to cause such problems. The regulatory aim, therefore, is about as close as can be to the traditional microprudential bank regulatory aims of protecting the federal DIF and limiting the use of insured deposits by restricting the scope of bank activities. It is true that the relative lack of geographic and portfolio diversification in many community banks can make them vulnerable to localized economic problems. But that is just the kind of problem that traditional microprudential regulation has been concerned with addressing.

[P]re-crisis statutes and regulations reflected what I have termed a unitary approach to banking regulation. The core of banking regulation could be explained with a relatively simple narrative, by which deposit insurance and access to the discount window had been granted to depository institutions in order to forestall runs and panics. The resulting moral hazard and the use of insured deposits as a funding source for these institutions justified everything from capital requirements to limitations on banks getting into nonbanking businesses. ..
Of course, banking law had not only tried to protect the DIF from the risky activities of banks and their affiliates. It had also, albeit far less explicitly, tried to protect banks from nonbank competition and, to some degree, from each other.3 Just as banks were supposed to stick to their knitting--the business of banking--so everyone else was supposed to stay out of that business..
The financial crisis has confirmed that the pre-crisis regulatory structure reflected a view of the financial system that was at once too broad and too narrow. It was too broad in that prudential rules generally applied to all banks and bank holding companies through a microprudential approach focused on the soundness of each individual bank. .. [T]he principles informing regulation were basically the same whether the institution was a community bank or a holding company with a $1 trillion balance sheet whose failure might shake the entire financial system.
The prudential regulatory structure was too narrow in that it did not extend to firms and activities outside of banking organizations, even those that could pose a threat to financial stability, because the soundness of the federal deposit insurance system was not implicated. Thus Lehman Brothers, whose failure did seriously shake the financial system, was not subject to even the microprudential standards applicable to bank holding companies…
…
One regulatory innovation in Dodd-Frank that is particularly salient for present purposes was the creation of different categories of banking organizations--largely, but not exclusively, on the basis of total assets--to which different regulatory requirements are to apply.

GARRETT: What progress are you making on actually completing and complying with this -- more than the spirit of cost-benefit analysis and rulemaking?
YELLEN: Well, the Federal Reserve strongly supports analyzing the cost and benefits of rules that it puts into effect, and we've done a great deal of that. An example I could give you is in connection with our Basel capital rulemaking where we participated in extensive cost-benefit analysis hopefully with other regulators.
GARRETT: Would you say you're satisfied with how it came out with Volcker?
Because we had no indication that a cost-benefit analysis was done. And I asked Governor Tarullo who was here where it is, because we have not seen it. So two years later, it seems like on something that's important as that, it was not done.
Do you believe it was done in that situation?
YELLEN: Well, I think -- I think what's important in the case of Volcker is that Dodd-Frank required the Federal Reserve -- in essence the decision about the cost and benefits of putting those restrictions in place were decided by Congress, taking account of what the likely cost and benefit would be.
And our job has been to implement it. We have certainly taken into account, issued a proposed rule, received a wide range...
GARRETT: Right.
YELLEN: ... thousands and thousands of comments.
GARRETT: I appreciate that. My time is very limited. And so I would encourage that a true cost-benefit analysis, one where I could actually say please submit to -- for the record, that it be submitted to Congress, which, I think in anyone's estimation, was not done fully in Volcker.
Speaking of Governor Tarullo, you know, the president has not appointed anyone to fill the position of supervisory division vice chair.
YELLEN: Vice chair.
GARRETT: Would you say that Governor Tarullo is effectively holding that position until that is completed, until the appointment is made?
YELLEN: Well, we operate at the board through a committee system.
GARRETT: Yes.
YELLEN: I usually have three governors and a chair. And Governor Tarullo heads the board's banking supervision committee.
GARRETT: So...
YELLEN: In that sense, he certainly takes the lead.
GARRETT: ... takes that role.
So would you...
YELLEN: But all of us are involved and all of us are responsible.
GARRETT: But in light of your comment, would you commit, then, to have the -- Governor Tarullo come and testify on federal rulemaking before this committee, since he seems to be filling that role until the president makes the...?
YELLEN: He has done a great deal of testifying on these topics.
GARRETT: Just on that topic, we can ask him?
YELLEN: On all topics.
(CROSSTALK)
GARRETT: I understand. I guess I'm asking for a commitment that we can have him come back in that role and testify before the committee on rulemaking.
YELLEN: Well, you know, I don't want to commit as to what he's going to do, but he has certainly taken the lead role in testifying on these topics.

I am committed to using the Fed's supervisory and regulatory role to reduce the threat of another financial crisis. I believe that capital and liquidity rules and strong supervision are important tools for addressing the problem of financial institutions that are regarded as "too big to fail." In writing new rules, however, the Fed should continue to limit the regulatory burden for community banks and smaller institutions, taking into account their distinct role and contributions. Overall, the Federal Reserve has sharpened its focus on financial stability and is taking that goal into consideration when carrying out its responsibilities for monetary policy. I support these developments and pledge, if confirmed, to continue them.

Regulatory policies can lean against emerging asset bubbles and the vulnerabilities that attend them by restraining financial institutions from excessively extending credit. In addition, such policies can build resilience in the financial system, enhancing its ability to absorb and shrug off unexpected losses from any source, including sharp asset price declines.

Of course, monetary policy also has the power to lean against the growth of asset bubbles. While there could be situations in which monetary policy might be needed to try to limit the growth of a bubble, in my opinion such use would represent a failure of regulatory policy, which represents a more tailored response than the flattening out of aggregate demand that would likely result from contractionary monetary policy.

The U.S. regulatory system is fragmented, and, hence, it takes time to choose and implement policies and calibrate them appropriately. It takes time to cooperate, coordinate, and harmonize responses. But such is today's imperative. We must complete in a timely fashion the post-Basel III and Dodd-Frank requirements. It is particularly important to increase the amount, and improve the quality, of required minimum capital; to continue stress testing and capital planning; and to reduce overreliance on unstable short-term wholesale funding. These reforms will build resilience to whatever shocks may come, and will reduce the potential for asset bubbles and excessive credit growth, leverage, maturity transformation, reliance on unstable short-term wholesale funding, and, thus, the potential for future financial crises.

Still, if regulators become fixated on the tools at the expense of compliance and enforcement, the tools themselves will be meaningless. Only when such tools--be they capital-focused, liquidity-focused, margin--and haircut-focused, or underwriting-focused--are fully embedded into a comprehensive system of prudential regulation will they reach their potential in mitigating the growth of asset bubbles and providing resiliency against the awful consequences attendant to their destruction.

HULTGREN: Mr. Chairman, as you know, Dodd-Frank requires the Fed to adopt procedures to implement the new limitations on the 13(3) authority, its 13(3) authority. It's now been three years later and the Fed still has not done so. How do you justify the Fed's three-year delay in implementing these basic restrictions on the Fed's authority to bail out non-bank firms?

BERNANKE: Well, first of all, I think that the law is very clear about what we can and cannot do. And I don't think that the absence of a formal rule would allow us to do something which the law prohibits. And I mentioned earlier that the law prohibits us from bailing out individual firms using 13(3). And there would be no way we could do that.

We have made a lot of progress on that rule and I anticipate that we will have that out relatively soon.

Many of the key problems related to shadow banking and their potential solutions are still being debated domestically and internationally, but some of the necessary steps are already clear.

First, we need to increase the transparency of shadow banking markets so that authorities can monitor for signs of excessive leverage and unstable maturity transformation outside regulated banks. Since the financial crisis, the ability of the Federal Reserve and other regulators to track the types of transactions that are core to shadow banking activities has improved markedly. But there remain several areas, notably involving transactions organized around an exchange of cash and securities, where gaps still exist. For example, many repurchase agreements and securities lending transactions can still only be monitored indirectly. Improved reporting in these areas would better enable regulators to detect emerging risks in the financial system.

Second, we need to reduce further the risk of runs on money market mutual funds. Late last year, the Council issued a proposed recommendation on this subject that offered three reform options. Last month, the SEC issued a proposal that includes a form of the floating net asset value (NAV) option recommended by the Council.

Third, we need to be sure that initiatives to enhance the resilience of the triparty repo market are successfully completed. These marketwide efforts have been underway for some time and have already reduced discretionary intraday credit extended by the clearing banks by approximately 25 percent. Market participants, with the active encouragement of the Federal Reserve and other supervisors, are on track to achieve the practical elimination of all such intraday credit in the triparty settlement process by the end of 2014.

Completing these three reforms would represent a strong start to the job of reducing systemic risk in the short-term wholesale funding markets that are key to the functioning of securities markets.