The emphasis in Basel III on improving the quality and quantity of capital is an important regulatory response to the financial crisis. Clearly we need to focus on the narrow definitions of capital – that which can readily absorb losses.

[N]o one's interests are served by the imposition of ineffective or burdensome rules that lead to excessive increases in costs or unnecessary restrictions in the supply of credit. Increased coordination and cooperation among regulators, under the auspices of the council where appropriate, should serve not only to improve our management of systemic risk, but also reduce the extent of duplicative, inconsistent, or ineffective rulemakings. More generally, in evaluating alternative approaches to mitigating systemic risks, regulators must aim to avoid stifling reasonable risk-taking and innovation in financial markets, as these factors play an important role in fostering broader productivity gains, economic growth, and job creation.

[T]he challenge facing the Board is to enhance supervision, oversight, and prudential standards of major derivatives market participants in a manner that promotes more-effective risk management and reduces systemic risk, yet retain the significant benefits of derivatives to the businesses and investors who use them to manage financial market risks.

"We really do need to think about redefining the scope of legitimate financial activities of the commercial banks,” Hoenig said, voicing a previously stated view. “That means to break them up, in essence."

Too often the questions asked are: What is most beneficial to the banks of my particular country? Do the regulations bolster or harm my "national champion"? The focus shifts away from the goal of bolstering global financial stability to finding ways of tilting or adjusting the new standards to achieve a national competitive advantage.

This is in not in anyone's interest. As discussed earlier, every nation has an interest in promoting financial stability globally, since the effects of systemic financial stress in one place can swiftly spread throughout the global economy. Moreover, although a relatively loose regulatory regime may attract business from other financial centers, there is no free lunch here. A more lax regulatory regime is likely to expose that country’s taxpayers to huge tail risks.

[W]e currently operate with a financial system that is largely regulated on a country-by-country basis.

This is not tenable. What’s required is not some global authority dictating what national authorities can do but instead greater cooperation and trust in exchanging information and agreement on harmonized standards such as those laid out in the Basel III capital requirements and the CPSS-IOSCO Principles for Financial Market Infrastructures. There needs to be a good faith commitment to try to achieve a level playing field. The regulations and supervisory practices that are put in place should be determined by what is good for the public good writ large, rather than what benefits some narrow set of private financial institutions or markets.

As we have learned all too well, a financial system dominated by a handful of large institutions is unlikely to be resilient in the face of a crisis. My view is that a diffuse financial system--one with a diverse range of institutions of varying size and complexity--is preferable to a system that is highly concentrated.

In fact, the need for diversification is one of the great lessons of the crisis.omplexity--is preferable to a system that is highly concentrated.

Importantly, title 8 of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) contains provisions aimed at improving the transparency, resilience, and financial strength of clearinghouses, which the act calls financial market utilities. Recognizing the systemic importance of clearinghouses, title 8 also challenges U.S. regulatory authorities to improve and better coordinate their oversight of these institutions...

...Because the failure of, or loss of confidence in, a major clearinghouse would create enormous uncertainty about the status of initiated transactions and, consequently, about the financial positions of clearinghouse participants and their customers, strong risk management at these organizations as well as effective prudential oversight is essential.

...

Broadly speaking, the recent financial reform legislation bears on the future structure and role of clearinghouses in two different ways. First, it aims to increase the resilience of these critical institutions against severe financial shocks, the issue that I have emphasized thus far. Second, it also encourages the greater development and use of clearinghouses to address weaknesses identified in other parts of the financial system. Of course, increased reliance on clearinghouses to address problems in other parts of the system increases further the need to ensure the safety of clearinghouses themselves. As Mark Twain's character Pudd'nhead Wilson once opined, if you put all your eggs in one basket, you better watch that basket.

In banking and a number of other industries, many contacts across the Southeast region of the country are increasingly giving voice to claims that this re-regulation is overreaching and potentially destructive. I frequently hear—across a range of industries—that the growing cost of compliance will drive out investment and hiring. As a current banking supervisor who has a background in the private sector, I see both sides of this concern. Let me just say that, to maximize the economy's potential, I believe that in the coming years we need to strike the right balance in all regulated sectors.

It would be unrealistic, even dangerous, to believe that asset bubbles, excessive leverage, poor risk assessment, and the crises such phenomena produce can all be prevented. The goal of the regulatory regime should be to reduce the likely incidence of such crises and, perhaps more importantly, to limit their severity when they do occur. This argues for fostering a financial sector capable of withstanding systemic stresses and still continuing to provide reasonably well-functioning capital intermediation through lending and other activities. The aim is not to avoid all losses or any retrenchment in lending and capital markets. It is to prevent financial markets from freezing up as they did in the latter part of 2008.

[Despite provisions in the Dodd-Frank bill,] the FDIC retains considerable discretion in the use of funds to limit losses to some creditors, and the Treasury can invoke orderly resolution for firms that have not been subject to enhanced regulation. The Fed also retains some discretionary power to lend to non-bank entities. This creates continued uncertainty about possible rescues, as well as gaps in our ability to provide clear, credible constraints on the safety net.

As I have said, [stress tests] have proven their usefulness in the crisis. Quantifying the risks at large financial institutions is a complex and costly process that is vulnerable to manipulation. A disciplined and well-organized supervisory process for validating those assessments strikes me as well worth the costs. Stress tests are not a panacea, however. In a sense they are only as good as the imagination of the scenario designers, who need to resist the temptation to dismiss extreme scenarios as too far-fetched or focus too much attention on preparing for the last war.

There are those who believe we have made great strides with Dodd-Frank and if we implement it well, all will be fine. Some believe that that the industry is over-regulated, which may be true, but we should not confuse over-regulated with well-regulated. And some of us are certain that in spite of all that’s been done and debated, the soundness of the largest financial institutions and the systemic risks they continue to pose is no better. In my view, it is even worse than before the crisis. As well-intentioned as the Dodd-Frank Act may be, it will not improve outcomes.

Today, I am convinced that the existence of too big to fail financial institutions poses the greatest risk to the U.S. economy. The incentives for risk-taking have not changed post-crisis and the regulatory factors that helped create the crisis remain in place. We must make the largest institutions more manageable, more competitive, and more accountable. We must break up the largest banks, and could do so by expanding the Volcker Rule and significantly narrowing the scope of institutions that are now more powerful and more of a threat to our capitalistic system than prior to the crisis.

It is ironic that in the name of preserving free market capitalism in this country, we have undermined it so deeply.