There are good reasons to think that these developments have made the financial system more resilient to shocks originating in the real economy and have made the economy less vulnerable to shocks that start in the financial system. Borrowers have a greater variety of credit sources and are less vulnerable to the disruption of any one credit channel; risk is dispersed more broadly to people who are most willing to hold and manage it. One can see the effects of these changes in the reduced incidence of financial crises in recent years. From the 1970s through the early 1990s, we seemed to be in almost continuous crisis mode. These crises were centered on depository institutions, and because borrowers were so dependent on depository institutions for credit availability, problems at depository institutions meant problems for the financial system and for the economy more generally.

...

But we certainly should not read this experience as meaning that we are free of systemic risk--the risk of financial-sector problems spilling into the real sector or aggravating already difficult economic circumstances. Indeed, I see several reasons for carefully considering the potential for such problems to emerge.

New players and new instruments have become important since 2002, when the last adverse credit cycle peaked. New and already existing market participants are maneuvering for greater shares in a rapidly evolving market structure. Although leverage has declined in the nonfinancial businesses whose credit is being priced and traded, it may well have increased in the structure of intermediary finance. In any event, the growth of tranched CDOs and other structured credit products with substantial embedded leverage has made it more difficult to assess the degree of leverage of individual institutions or of the financial system as a whole.

In addition, the extraordinarily rapid growth of credit derivatives markets in the past few years has occurred against the backdrop of relatively benign macroeconomic performance--good global growth, low inflation, historically high corporate profits and low business failures, and reasonably predictable monetary policies. Partly as a consequence, the prices of financial assets seem to embody relatively low expected volatilities and relatively little reward for taking credit risk or for extending the duration of investor portfolios.

We need to accept that accidents will happen--that asset prices will fluctuate, often over wide ranges, and those fluctuations will be driven in part by trading strategies, by the cycles of greed and fear that have always been with us, and by the ebb and flow of competition for market share. The fluctuations will result in redistributions of wealth and, on occasion, will confront us with financial crises. But we cannot and should not try to prevent this process through a monetary policy that puts special emphasis on stabilizing asset prices or through regulatory policies that limit access to markets by qualified participants or that attempt to restrain competition materially. Monetary policy that proactively leans against asset price movements runs a considerable risk of yielding macroeconomic results that fall short of maximum sustainable growth and price stability. Regulatory policies that try to prevent failures of core participants or others under all conceivable circumstances will tend to stifle innovation and reduce our economy's potential for long-run growth.

Both market participants and public authorities should understand that, despite our best efforts, crises are inevitable, and so we need to work on crisis management as well. Here, too, cooperation among authorities here and abroad is critical. We must understand the market structures and vulnerabilities and the objectives and constraints under which authorities with different jurisdictions would be working in those circumstances.

Inevitably, uncertainty on the part of market participants and public authorities will be heightened in the event of market turmoil, and that uncertainty can feed on itself. Both authorities and participants need to think through how they will handle such crises. For the authorities, that process includes considering how to resolve any failures of large institutions in ways that impose costs on shareholders and uninsured liability holders while preserving orderly markets. Such a resolution will be necessary to limit the moral hazard of any interventions that we are forced to undertake. Market participants need to consider how they would settle contracts and work with troubled borrowers in a distress situation. More planning will reduce the rise in uncertainty in a crisis and the likelihood that fear will lead to precipitous actions that are in no one's best interest.

Leveraged arbitrage activity, so some of the literature suggests, is likely to reduce volatility in normal times and increase it in times of stress, because of the greater financial constraints faced by leveraged funds relative to larger, more diversified banks and investment banks. Whether this matters in a systemic sense or not depends on the heterogeneity of funds and how correlated their exposures are with those of the major banks and investment banks.

The goal of regulation should be to preserve those [economic] benefits while achieving important public policy objectives, including financial stability, investor protection, and market integrity. Although financial innovation promotes those objectives in some ways, for example by allowing better sharing of risks, certain aspects of financial innovation--including the complexity of financial instruments and trading strategies, the illiquidity or potential illiquidity of certain instruments, and explicit or embedded leverage--may pose significant risks. These risks should not be taken lightly.

Central banks and other regulators should resist the temptation to devise ad hoc rules for each new type of financial instrument or institution. Rather, we should strive to develop common, principles-based policy responses that can be applied consistently across the financial sector to meet clearly defined objectives.

The conditions we see prevailing in global financial markets today reflect a range of different factors, some fundamental and others that are less likely to be enduring. The most effective thing that policymakers and market participants can do in what is a necessarily uncertain world is to work to ensure that the shock absorbers are strong relative to the range of potential economic and financial outcomes.

The development of deeper and more resilient financial markets is important for economies to be able to cope better with exchange rate flexibility and capital mobility. And financial strength is an important part of the arsenal of macro policy tools, for monetary policy is less effective in cushioning the effects of asset price and demand shocks in circumstances where the banking sector is impaired.

Nonetheless, during my tenure at the Fed, the FOMC has had to react to a number of important and difficult challenges: the Asian financial crisis, the Russian debt default, major movements in asset prices, the acceleration in productivity, Y2K, 9/11, and the risk of deflation. All of these issues generated policy questions that did not fit neatly into any familiar textbook framework. They exemplify how, when making tough decisions in unusual circumstances, it's important to follow sound policy-making principles:

• Look at a wide range of data and information, instead of one or two summary indicators;
• Use cogent economic theory to shape analysis;
• And respect the risks of undesirable outcomes for growth or inflation, even in environments that appear benign.

In response to this series of financial panics, the Congress in 1913 founded the Federal Reserve to provide the nation with a safer, more flexible, and more stable monetary and financial system. Specifically, the Fed was established "to furnish an elastic currency, to afford means of rediscounting commercial paper, [and] to establish a more effective supervision of banking in the United States."

Thus far, the market-based approach to the regulation of hedge funds seems to have worked well, although many improvements can still be made (Bernanke, 2006). In particular, risk-management techniques have become considerably more sophisticated and comprehensive over the past decade. To be clear, market discipline does not prevent hedge funds from taking risks, suffering losses, or even failing--nor should it. If hedge funds did not take risks, their social benefits--the provision of market liquidity, improved risk-sharing, and support for financial and economic innovation, among others--would largely disappear.

In answering audience questions earlier, Poole spoke about how observers can judge whether or not the Fed will intervene in economic crises. "The goal ought to be to be able to write something [rules for intervention] down in a formal fashion," Poole said. "We're not there yet but I'll tell you there's much more predictability than you might realize and ... there are events that can happen where you won't have any doubt as to how the fed is going to respond." He cited the failure of Long Term Capital Management and 9/11 as an examples where uncertainty was rampant and spreads "moved to a surprisingly large extent."

As reported by Market News

{The President's Working Group on Financial Markets} did not have a meeting on February 27. It's a usual practice, whenever there is some stress in financial markets, for the staff, the senior staff or deputies to be in touch with each other just to see what are you seeing, what are you seeing, just trying to gather information to see if anything is going on.

Financial shocks take many forms. Some, such as in 1987 and 1998, involve a sharp increase in risk premia that precipitate a fall in asset prices and that in turn leads to what economists and engineers call "positive feedback" dynamics. As firms and investors move to hedge against future losses and to raise money to meet margin calls, the brake becomes the accelerator: markets come under additional pressure, pushing asset prices lower. Volatility increases. Liquidity in markets for more risky assets falls.

In systems where credit is more market-based and more credit risk is in leveraged financial institutions outside the banking system, a sharp rise in asset-price volatility and the concomitant reduction in market liquidity, can potentially have greater negative effects on credit markets. If losses in these institutions force them to withdraw from credit markets, credit availability will decline, unless or until other institutions in a stronger financial position are willing to step in. The greater connection between asset-price volatility, market liquidity and the credit mechanism is the necessary consequence of a system in which credit risk is dispersed outside the banking system, including among leveraged funds. This does not make the system less stable, though, only different. For if risk is spread more broadly, shocks should be absorbed with less trauma. Moreover, the system as a whole may be less vulnerable to distortions introduced by the moral hazard associated with the access that banks have to the safety net.

What should policymakers to do mitigate these risks?

We cannot turn back the clock on innovation or reverse the increase in complexity around risk management. We do not have the capacity to monitor or control concentrations of leverage or risk outside the banking system. We cannot identify the likely sources of future stress to the system, and act preemptively to diffuse them.

The most productive focus of policy attention has to be on improving the shock absorbers in the core of the financial system, in terms of capital and liquidity relative to risk and the robustness of the infrastructure.