The preferences of foreign investors for highly rated U.S. assets, together with similar preferences by many domestic investors, had a number of implications, including for the relative yields on such assets. Importantly, though, the preference by so many investors for perceived safety created strong incentives for U.S. financial engineers to develop investment products that "transformed" risky loans into highly rated securities...

To be clear, these findings are not to be read as assigning responsibility for the breakdown in U.S. financial intermediation to factors outside the United States. Instead, in analogy to the Asian crisis, the primary cause of the breakdown was the poor performance of the financial system and financial regulation in the country receiving the capital inflows, not the inflows themselves. In the case of the United States, sources of poor performance included misaligned incentives in mortgage origination, underwriting, and securitization; risk-management deficiencies among financial institutions; conflicts of interest at credit rating agencies; weaknesses in the capitalization and incentive structures of the government-sponsored enterprises; gaps and weaknesses in the financial regulatory structure; and supervisory failures. In reflecting on this experience, I have gained increased appreciation for the challenges faced by policymakers in emerging market economies who have had to manage large and sometimes volatile capital inflows for the past several decades.

To be effective, regulation must be supported by strong supervision.

The debate ought to be who is in the safety net and who is out, being clear about who is in, regulating them appropriately. And then letting the rest deal with risk on their own. I think the markets are capable of doing that. And I think that requires a clear commitment for us to stay out of the process of bailing out large institutions that are outside the safety net.

[B]ecause of the specific language contained in the [Dodd-Frank] act, this exemption for traditional bank derivatives activities does not apply to foreign banking firms that have access to the Federal Reserve's discount window through their U.S. branches. A possibly unintended effect of the act's push-out provision may be to require some foreign firms to reorganize their existing U.S. derivatives activities to a greater extent than U.S. firms.

The new Congress and the new staff in the White House have their work cut out for them. You cannot overstate the gravity of their duty on the economic front. Over the years, their predecessors―Republicans and Democrats together―have dug a fiscal sinkhole so deep and so wide that, left unrepaired, it will swallow up the economic future of our children, our grandchildren and their children. They must now engineer a way out of that frightful predicament without thwarting the nascent economic recovery.

I have been outspoken about the limits of monetary policy as a salve for the nation’s fiscal pathology. The Fed has done much, as I see it, to provide the bridge financing until the new Congress gets to work restructuring the tax and regulatory incentives American businesses need to confidently expand their payrolls and capital expenditures here at home.

The Fed’s only engagement with [the Consumer Financial Protection Bureau] is to fund it. The law requires that the equivalent of 10 percent of Federal Reserve System expenses be transferred to the CFPB in 2011, 11 percent in 2012, and 12 percent in 2013 (where it will stay fixed in perpetuity).

I am concerned about this method of funding for the Bureau. The amount of money allocated in the law is not based on any careful assessment of what the needs of the Bureau will be as it attempts to fulfill the mandate of the Congress with regard to consumer protection. Nor is there any mechanism for changing these amounts going forward, should market conditions change, or if the needs of the Bureau change.

I draw several lessons from our collective experience in dealing with the crisis. (My list is by no means exhaustive.) The first lesson is that, in a world in which the consequences of financial crises can be devastating, fostering financial stability is a critical part of overall macroeconomic management...

Second, the past two years have demonstrated the value of policy flexibility and openness to new approaches. During the crisis, central banks were creative and innovative, developing programs that played a significant role in easing financial stress and supporting economic activity. As the global financial system and national economies become increasingly complex and interdependent, novel policy challenges will continue to require innovative policy responses...{Emphasis added.}

Third, as was the focus of my remarks two years ago, in addressing financial crises, international cooperation can be very helpful; indeed, given the global integration of financial markets, such cooperation is essential. Central bankers worked closely together throughout the crisis and continue to do so. Our frequent contact, whether in bilateral discussions or in international meetings, permits us to share our thinking, compare analyses, and stay informed of developments around the world. It also enables us to move quickly when shared problems call for swift joint responses, such as the coordinated rate cuts and the creation of liquidity swap lines during the crisis.

Basel III is not a perfect agreement, of course. There are things we would have done differently if we were writing a capital regulation on our own... But it is a major step forward for capital regulation. It will raise minimum requirements substantially, ensure that regulatory capital is truly loss absorbing, and discourage some of the risky activities for which the pre-crisis regime required far too little capital.

It is also possible to overreact, shutting down a particular financial market practice which in reality does not pose a systemic risk. During the technology boom of the 1990s, many argued that a bubble had formed and that policymakers should address the bubble with appropriate action. Still, I think few would now argue that we would have wished to miss out on the technology boom of the 1990s. Closing off those developments through aggressive policy might have deprived the economy of important advances in productivity.

If such organizational complexity [of large financial institutions] imposes a high social cost by impeding recovery plans and resolution, providing incentives to reduce complexity may be warranted. For example, collateralization or capital requirements on intragroup exposures or parent guarantees could internalize for the firm some of those social costs. Alternatively, more direct supervisory requirements may be necessary for addressing the improvement of information systems or the separability and preservation of critical payment systems.

Instead of more regulation, we need better-designed regulation that recognizes incentives and tries to address moral hazard so that market discipline can work. Overly proscriptive regulation is counterproductive - it increases the incentives to evade it, which ultimately defeats it. Financial innovation spurred by the desire to evade regulation and relocating activities outside of regulation’s reach are not productive, but they are an expected outcome if regulations are not well designed. Market discipline is an essential part of our market-based economy, and regulation should be designed to enhance it, not thwart it.

This requires scaling back some of the safety net subsidies that have risen over the years and increasing capital requirements.

[T]o paraphrase the early 20th century progressive Clarence Day―the once-ubiquitous contributor to my favorite magazine, The New Yorker―“Too many (theorists) begin with a dislike of reality." The reality of fiscal and regulatory policy inhibiting the transmission mechanism of monetary policy is most definitely present and is vexing to monetary policy makers. It is indisputably a significant factor holding back the economic recovery.

[I]f fiscal and regulatory authorities are able to dispel the angst that businesses are reporting and put together a credible plan for deficit reduction that does not choke off growth, further accommodation might not even be needed. If job-creating businesses are more certain about future policy and are satisfactorily incentivized, they are more likely to take advantage of low interest rates, release the liquidity they are hoarding and invest it robustly in hiring and training a workforce that will propel the American economy to new levels of prosperity. This would render moot the argument for QE2, or a second round of quantitative easing. The key is to remove or reduce the tax and regulatory uncertainties that act as an impediment to businesses as they respond to increases in final demand. I think most all would consider this to be a far more desirable outcome than being saddled with a bloated Fed balance sheet.

There’s no question in my mind that there’s going to be some consequences for lending margins. Careful review of this suggests that the adjustment to lending margins is going to be quite modest.

In the period leading up to this most recent crisis, the regulatory authorities, like the industry, trusted that the market would self-regulate. It didn’t, it can’t and it won’t. The industry's structure and incentives are now inconsistent with the market being the disciplinarian.

The Volcker Rule does not reinstitute Glass-Steagall. It does improve the odds toward financial stability by instituting a partial return to the separation of commercial and investment banking activities. It strives to affirm the principle that those institutions that by their franchise have access to the safety net should be separated from those firms that are free to speculate with shareholder, not taxpayer, funds.

Paul has it right.

....

As a Swiss central banker once insisted to me many years ago, “ [I]t is the central bank's job to focus on the long run so that the short run can take care of itself.”  For me, one certain lesson from this most recent crisis is that both the industry and supervisory authorities lost sight of the long run.

So what about the long-run consequences [of higher capital standards]? It would be prudent to assume that requiring banks to hold more capital and higher cost capital is likely to result in somewhat higher lending spreads.

Although any increase will be a real cost, this appears to be a necessary and appropriate price to pay for a much more resilient financial system. The cost represented by higher lending spreads has to be weighed against the benefits of a more robust and resilient banking system. Recent years have surely taught us that easy access to credit that is underpriced because it is not backed by sufficient capital is not a sustainable route to prosperity. Indeed, to the extent that tougher standards reduce the misallocation of resources in the real economy that often accompanies periods of financial excess, ensure more consistent access to finance over time and encourage investment by holding out the prospect of greater economic stability, the new standards could be consistent with a more rapid sustainable growth rate over the long run.