To date, reform in financial regulation and supervision has focused mainly on large regulated institutions: Three examples are the just-announced Basel III capital rules, much of the Dodd-Frank Act, and the Federal Reserve's revamping of its large holding company supervision. Of course, attention has also been paid to the second source of systemic risk, notably in Dodd-Frank's provisions for prudential supervision of payments, clearing, and settlement systems. But more will need to be done in this area, particularly as new constraints applicable to large regulated institutions push more activity into the unregulated sector.

[M]aking financial reform work will not be easy. We face complex problems that will require a comprehensive, multipronged approach. But make no mistake; reform is critical for ensuring our long-term economic and financial stability. And much of that reform will address the implications of the increasing interconnectedness of the global payment, clearing and settlement infrastructure that supports financial market operations today.

My own sense is that the new facility will not have the credibility needed to deter the perception of too big to fail until it is actually used successfully.

I do not believe it is appropriate or even possible for regulators to urge banks to make loans that are outside their risk tolerance or that would be unsafe or unsound. But we can and should be sure that supervisory policies do not impede the flow of credit to all eligible borrowers. That's why the Federal Reserve and other regulatory agencies have worked so hard during the past few years to ensure that while banks appropriately recognize loan problems they also can continue to make loans that are safe and sound.

[I]t seems to me that capital and liquidity requirements are intrinsically backwards-looking. We need forward-looking instruments for what is intrinsically a forward-looking problem. And that’s a key reason why taxes, based on market information, will work better.

My view is that no law can completely eliminate the kinds of collective investor and regulator mistakes that lead to financial crises. These mistakes have taken place periodically for centuries. They will certainly do so again. And once these crises happen, there are strong economic forces that lead policymakers—for the best of reasons—to bail out financial firms. In other words, no legislation can completely eliminate bailouts...

So, that’s my first point: Bailouts are inevitable during financial crises. Let me move to the second: Anticipation of bailouts creates inefficiency in the allocation of real investment...

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As in the pollution case, using taxes to discourage excessive risk saves the government from actually trying to solve the cost-minimization problem of financial firms...

Here’s what I have in mind. Suppose that, for every relevant financial institution, the government issues a “rescue bond.”  The rescue bond pays a variable coupon equal to 1/1,000 of the transfers made from the taxpayer to the institution or its stakeholders. (I pick 1/1,000 out of the air; any fixed fraction will do.) Much of the time, this coupon will be zero, because bailouts aren’t necessary and so the firm will not receive transfers. However, just like the institution’s stakeholders, the owners of the rescue bond will occasionally receive a large payment. In a well-functioning market, the price of this bond is exactly equal to the 1/1,000 of the expected discounted value of the transfers to the firm and its stakeholders. Thus, the government should charge the financial firm a tax equal to 1,000 times the price of the bond. Note that the “rescue” bond is only a measurement device. In particular, it is not part of the financial firm’s rescue. 

Notice that this approach could be used for a wide variety of financial institutions, including nonbanks. In principle, the government need not figure out in advance exactly which are systemically important and which are not. Instead, it could simply issue a rescue bond for every institution. Then the market itself could reveal how systemically important each institution is through the price of its rescue bonds. Of course, markets are not always perfect. It may not always be appropriate to rely only on market measures to compute the appropriate taxes. However, even in these cases, the prices of rescue bonds would contain valuable information that should be an important input into the supervisory process.

"We need clarity" in light of things such as the passage of major health-care and financial regulatory-reform legislation, and that is now lacking, Federal Reserve Bank of Dallas President Richard Fisher told CNBC television Wednesday.

"There is too much confusion" right now and that is leading to slower economic growth, Fisher said.

[G]iving all macroprudential responsibilities to a single agency risks creating regulatory blind spots, as--in the United States, at least--the skills and experience needed to oversee the many parts of our complex financial system are distributed across a number of regulatory agencies.

Let me first talk about market-based mechanisms as a form of prompt corrective action. I think that we have to acknowledge that heavy-handed regulation that focuses on what activities institutions can and cannot do runs the risk of firms devising ways of getting around the rules, forcing activities into the unregulated sector and creating risks elsewhere. Regulators can also find themselves behind the curve as financial markets evolve and innovation changes the way firms function. Discretionary supervision and regulation alone are not sufficient to prevent excessive risk-taking or prevent future crises. Thus, I think reform must seek ways to strengthen market discipline rather than seeking to override or replace markets in controlling risk-taking.

[I]t's realistic to assume we can't achieve perfect symmetry between the public being at risk and private gain

To reduce the likelihood of problems in the future, Rosengren said, "holding more capital will reduce the probability of insolvency," which he said is "particularly important if failure has broad ramifications."

So he recommended raising minimum capital standards. He said banks should "reserve for more than just accrued loss," which he said is "too influenced by accounting standards."

He said banks should "retain capital as problems emerge" and should "limit dividends and stock buybacks earlier" than they did in the recent crisis.

In my view, both [financial regulatory reform bills proposed by Congress] significantly understate the extreme economic forces that lead to bailouts during financial crises. Indeed, the opening language of the Senate bill actually declares that it will end taxpayer bailouts. This objective is laudable. But it is not achievable—and thinking that it is can lead to poor choices about the structure of financial regulation.

Such amendments [that would broaden audits of the Fed], if enacted, would seriously threaten monetary-policy independence, increase inflation fears and market interest rates, and damage economic stability and job creation

[W]e also emphasize that collecting more data is only part of the process of developing early warning systems. More fundamental, in our view, is the need to use data in a different way -- in a way that integrates the ongoing analysis of macro data to identify areas of interest with the development of highly specialized information to illuminate those areas, including the relevant instruments and transactional forms.

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We can easily imagine specifying ex ante a program of data collection that would look for vulnerabilities in the wrong place, particularly if the actual act of looking by macro- or microprudential supervisors causes the locus of activity to shift into a new shadow somewhere else.

We argue that the focus on a fixed set of metrics changes behavior in a way that diminishes the usefulness of the indicators. Given the dynamic nature of the financial system, the process of specifying these metrics inevitably leads to active management of these metrics, at which time they cease to fully reflect the risks that they were intended to capture.

{Editors Note:  A classic expression of Goodhart's Law}