The clear lesson is that the Fed had insufficient access to information about the financial landscape going into the crisis, meaning that it did not have a full understanding of the potential for feedback between the financial sector and the rest of the economy... As the crisis began, all eyes turned to the Fed as the lender of last resort. This always happens in a crisis—only the central bank can play the lender-of-last-resort role... Going forward, the Fed will also be at the center of all future crises because of this lender-of-last-resort role. Therefore, reforms should provide the Fed with direct access to detailed information across the entire financial landscape.

But the bigger problem is one of incentives. Under the current system, if the Federal Reserve makes a bad loan through the TAF or through the discount window, that loss appears on its balance sheet. It has every incentive to do a good job in assessing the borrower quality.

Now suppose instead that some other agency were responsible for providing this information to the Federal Reserve. What exactly are this other agency’s incentives to provide the Federal Reserve with the best possible information? This other agency is not going to suffer a loss for making a bad loan—the Federal Reserve is. Indeed, one can readily imagine that in the politically charged circumstances of a financial panic, this other agency’s objective might be to keep as many banks alive as possible. In these circumstances, the Federal Reserve would have no way to obtain reliable information from this other regulatory body and would have no way to make appropriately targeted loans. As it is, the Federal Reserve has not lost any money on either TAF or discount window loans made during this period.

To solve the too-big-to fail problem, we need to do two things. First, we need to develop a truly robust resolution mechanism that allows for the orderly wind-down of a failing institution and that limits the contagion to the broader financial system. This will require not only domestic legislation, but also intensive work internationally to address a range of legal issues involved in winding down a major global firm.

Second, we need to reduce the likelihood that systemically important institutions will come close to failure in the first place. This can be done by mandating higher capital requirements, improving the risk capture of those requirements and by requiring greater liquidity buffers for such firms.

If real reform were chiefly about the number of financial regulators in Washington--or even the precise relationships between financial regulation and the role of the central bank--we should find an institutional design among major financial centers around the world that lived up to its promise. We find no such example. Policymakers, in my view, should be more focused on what constitutes effective prudential supervision, rather than be diverted to the less consequential discussion as to who should perform it.

Government interventions during the past couple of years, however necessary, revealed a set of policy preferences. These expectations must be unlearned by market participants. Eradicating the too-big-to-fail problem should be the main policy goal.

If it cannot be achieved, the next-best regime may involve choosing a point between two competing models: regulating what financial institutions can do, and regulating how they do it (as Paul Tucker at the Bank of England set out). Clear rules – more focused on the what than the how – could free them to depart Washington’s lobbies and get back to business.

 I’m also concerned about those proposals under consideration that would move the regulatory and supervisory functions now held by the Federal Reserve to other agencies, new or existing... In my view, further disaggregation or fragmentation of regulatory oversight responsibility is not the appropriate response to our increasingly interconnected, interdependent financial system. Funneling information streams into diverse institutional silos leads to communication breakdowns and too often to failure to "connect the dots."

I have argued elsewhere that the most important step to ensuring long term financial stability is to establish clear and credible limits to the federal financial safety net – which has grown considerably as a result of the response to the crisis. I believe that the crisis itself was in no small measure the result of our not having clear limits on government support... If we retain a stance of official ambiguity as to when such protection will or will not be forthcoming in the future, then I suspect our susceptibility to disruptive financial crises will continue to grow, and with each crisis, the safety net will become ever more expansive. A more expansive safety net will inevitably require more stringent regulation, but regulatory systems are necessarily limited in their capacity to completely offset the incentive distortions due to the safety net. So just like ambiguity about the path of future fiscal policies, continued ambiguity about the financial safety net could limit our capacity for growth in the long run.

Some observers argue that the financial reform agenda should include changes in the role and governance of the Federal Reserve...   I know it might sound self serving for a Fed insider to object to such changes, but I believe such moves would present very serious risks to the effectiveness of monetary policy and ultimately to economic growth and stability...  The governance of the Federal Reserve System balances accountability, with ultimate authority resting in Washington, and independence, with the participation of non-political leaders from throughout the country.  While the performance of our economy in the last two years has clearly been unsatisfactory, and policy mistakes may have contributed to our problems, the Fed's balanced, hybrid governance structure has, I believe, given us a good record over the better part of three decades. Disrupting that balance would pose another long term challenge for our economy.

I have argued elsewhere that the most important step to ensuring long term financial stability is to establish clear and credible limits to the federal financial safety net – which has grown considerably as a result of the response to the crisis. I believe that the crisis itself was in no small measure the result of our not having clear limits on government support. Leverage and excessive risk-taking were encouraged by the belief that large parts of the financial system were implicitly protected, and those beliefs have been ratified. If we retain a stance of official ambiguity as to when such protection will or will not be forthcoming in the future, then I suspect our susceptibility to disruptive financial crises will continue to grow, and with each crisis, the safety net will become ever more expansive. A more expansive safety net will inevitably require more stringent regulation, but regulatory systems are necessarily limited in their capacity to completely offset the incentive distortions due to the safety net. So just like ambiguity about the path of future fiscal policies, continued ambiguity about the financial safety could limit our capacity for growth in the long run.

[Regulators should] designate banks in advance that are systemically important... Preparation is really important. We have to define 'systemic' to get things started to deal with this issue [of too big to fail].

We have to go back and think of some of the reasons why [excessive risk-taking] came about at these very large institutions -- without changing the structure that eliminated Glass-Steagall -- and the consequences of that... [Breaking apart very large firms] is a fair thing to consider.

Having experienced the damage that asset price bubbles can cause, we must be especially vigilant in ensuring that the recent experiences are not repeated.  All efforts should be made to strengthen our regulatory system to prevent a recurrence of the crisis, and to cushion the effects if another crisis occurs.  However, if adequate reforms are not made, or if they are made but prove insufficient to prevent dangerous buildups of financial risks, we must remain open to using monetary policy as a supplementary tool for addressing those risks--proceeding cautiously and always keeping in mind the inherent difficulties of that approach.

When the monetary authorities judge that important asset prices or rates of credit expansion are deviating from sustainable long-run trends, should they adjust their policy setting to damp those price and credit movements--beyond whatever actions might be called for to preserve macroeconomic stability over the usual two- to three-year planning horizon for monetary policy?

To preview, I don't think we know enough to answer those questions with any confidence--to judge whether the benefits of such extra action would outweigh the costs...

The difficulties I've just outlined lead me to a strong preference for using prudential regulation to deal with potential problems in credit and asset markets. Historically, bank supervision has been focused on individual institutions rather than on the system as a whole. Unfortunately, such microprudential regulation in practice was not as effective as it should have been, and an important challenge for policymakers will be to strengthen the supervision of individual institutions. However, the experience of this crisis also strongly suggests that policymakers need to pay close attention to developments across the financial system--that is, to engage in macroprudential supervision and regulation. Both microprudential and macroprudential oversight are essential to making the financial system more resilient to the inevitable cycles in asset prices, and less prone to large cycles.

Some additional potential regulatory devices are already under active consideration, both among U.S. bank supervisors and in international forums. These include proposals to create special charges on firms based on their systemic importance, to require contingent capital that would be available in periods of stress, and to counter pro-cyclical tendencies by establishing special capital buffers that would be built up in boom times and drawn down as conditions deteriorate. Each of these ideas has substantial appeal. A number of thoughtful proposals are being discussed, though each idea presents considerable challenges in the transition from good idea to fully elaborated regulatory mechanism.

Yet to gain traction are proposals for what might be termed structural measures--that is, steps that would directly affect the nature and organization of the financial services industry. But discussion of such concepts is clearly increasing.

One suggested approach is to reverse the 30-year trend that allowed progressively more financial activities within commercial banks and more affiliations with non-bank financial firms. The idea is presumably to insulate insured depository institutions from trading or other capital market activities that are thought riskier than traditional lending functions, although separating trading from hedging and other prudent practices associated directly with lending is not an altogether straightforward proposition.

In any case, this strategy would seem unlikely to limit the too-big-to-fail problem to a significant degree. For one thing, some very large institutions have in the past encountered serious difficulties through risky lending alone. Moreover, as shown by Bear Stearns and Lehman, firms without commercial banking operations can now also pose a too-big-to-fail threat. Still, imposition of higher capital and liquidity requirements for riskier trading and other capital market activities can, if well devised and implemented, achieve some of what proponents of this approach seem to have in mind.

For example, some firms gave loan officers incentives to write a lot of loans, or traders incentives to generate high levels of trading revenues, without sufficient regard for the risks associated with those activities. The revenues that served as the basis for calculating bonuses were generated immediately, while the risks might not have been realized for months or years after the transactions were completed. When these or similarly misaligned incentive compensation arrangements were common in a firm, the very foundation of sound risk management could be undermined by the actions of employees seeking to maximize their own pay. There is thus significant overlap between the interests of shareholders and of supervisors in the area of employee compensation.