Still, we have yet to address head-on the financial stability risks from securities financing transactions and other forms of short-term wholesale funding that lie at the heart of shadow banking. There are two fundamental goals that policy should be designed to achieve. The first is to address the specific financial stability risks posed by the use of large amounts of short-term wholesale funding by the largest, most complex banking organizations. The second is to respond to the more general macroprudential concerns raised by short-term collateralized borrowing arrangements throughout the financial system.

"The metrics of market valuations seem to be broadly within historical ranges," Mr. Bernanke said at an event hosted by the Hutchins Center on Fiscal and Monetary Policy. "The financial system is strong. The key financial institutions are well-capitalized." ... San Francisco Fed President John Williams, also speaking at the Hutchins event Thursday, said while the Fed's bond-buying programs clearly have lowered long-term borrowing rates, a lot of uncertainty remains about how they work, how much they help the economy and what their unintended consequences may be. Mr. Bernanke, however, said financial instability was the only potential risk from the bond-buying program "that I find personally credible, frankly."

Obviously, we were slow to recognize the crisis; I was slow to recognize the crisis. In retrospect, it was a traditional, classic crisis, but in a very, very different guise, different types of financial instruments, different types of institutions which made it for an historian like me more difficult to -- to see. Whether or not we could have prevented it or done more about it, that's another question. You know, by the time I became chairman, it was already 2006, and house prices were already declining. Most of the mortgages had been made. But, obviously, it would have been good to have recognized that earlier and tried to take more preventive action. That being said, we've done everything we can think of, essentially, to strengthen the Fed's ability to monitor the financial markets, to take actions to stabilize the economy and the financial system. So I think, going forward, we're much better prepared for -- to deal with these kinds of events than we were when I became chairman in 2006.

So there are a number of reasons why asset purchases, while effective, while I think they have been important, are less -- less attractive tools than traditional interest rate policy. And that's the reason why we've relied primarily on interest rates, but used asset purchases as a supplement when we've needed it to keep forward progress. I think that, you know, obviously, there are some financial stability issues involved there. We look at the possibility that asset purchases have led to bubbly pricing in certain markets or in excessive leverage or excessive risk-taking. We don't think that that's happened to an extent, which is a danger to the system, except other than that, when those positions unwind, like we saw over the summer, they can create some bumpiness in -- in interest rate markets, in particular. Our general philosophy on financial stability issues is, where we can, that we try to address it first and foremost by making sure that the banking system and the financial system are as strong as possible -- if banks have a lot of capital, they can withstand losses, for example -- and by using whatever other tools we have to try to avoid bubbles or other kinds of financial risks. That being said, I don't think that you can completely ignore financial stability concerns in monetary policy, because we can't control them perfectly and there may be situations when financial instability has implications for our mandate, which is jobs and inflation, which we saw, of course, in the Great Recession. So it's a very complex issue. I think it will be many years before central banks have completely worked out exactly how best to deal with financial instability questions. Certainly, the first line of defense for us is regulatory and other types of measures, but we do have to pay some attention to that.

Some investors “were thinking the Fed was going to keep buying forever, QE infinity,” Williams said today in a CNBC television interview from Jackson Hole, Wyoming. “We had always communicated that that’s not what our plan was.”

“Some of the adjustment in the bond market probably was kind of bringing people back to reality that this was a program that wasn’t going to continue forever,” he said. “And I think that, maybe, eliminates some of the froth in the bond market.”

The efficacy of this effort is the subject of significant debate, even internally within the FOMC. Some who question the efficacy, including myself, note that the effect of our purchasing MBS and driving down mortgage rates has certainly assisted a robust recovery in housing, and with it, construction jobs and manufacturing and transportation of materials that go into homes… [T]he Fed’s muscling of the yield curve has brought what has been a 30-year-long bond market rally to a crescendo…

Counteracting whatever benefits one can trace to the Fed’s unorthodox policies are some obvious costs. First, savers and others who rely on retirement monies invested in short-maturity fixed-income investments, such as bank CDs and Treasury bills, have seen their income evaporate while the rich and the quick, the big money players of Wall Street have become richer still.

Second, the standard return assumptions of 7.5 to 8 percent for retirement pools, as you well know, have been dashed (though I have always felt they were already calculated on an imaginary and politically convenient basis rather than a realistic one).

Third, accompanying the Fed’s growing balance sheet we have seen a dramatic expansion in the monetary base—the sum of reserves and currency. A basic understanding of demand-pull inflation is “too much money chasing too few goods.” Thus, the excess, currently nondeployed money could prove the kindling of an inflationary conflagration unless the Fed is nimble in managing its effect as it works its way into the economy’s production and consumption of goods and services.

A corollary of reining in this massive monetary stimulus in a timely manner is that financial markets may have become too accustomed to what some have depicted as a Fed “put.” Some have come to expect the Fed to keep the markets levitating indefinitely. This distorts the pricing of financial assets, encourages lazy analysis and can set the groundwork for serious misallocation of capital.

…

Whereas before, our portfolio consisted primarily of instantly tradable short-term Treasury paper, now we hold almost none; our portfolio consists primarily of longer-term Treasuries and MBS. Without delving into the various details and adjustments that could be made (such as considerations of assets readily available for purchase by the Fed), we now hold roughly 20 percent of the stock and continue to buy more than 25 percent of the gross issuance of Treasury notes and bonds. Further, we hold more than 25 percent of MBS outstanding and continue to take down more than 30 percent of gross new MBS issuance. Also, our current rate of MBS purchases far outpaces the net monthly supply of MBS.

The point is: We own a significant slice of these critical markets. This is, indeed, something of a Gordian Knot…

There is no Alexander to simply slice the complex knot that we have created with our rounds of QE. Instead, when the right time comes, we must carefully remove the program's pole pin and gingerly unwind it so as not to prompt market havoc. For starters though, we need to stop building upon the knot. For this reason, I have advocated that we socialize the idea of the inevitability of our dialing back and eventually ending our LSAPs. In June, I argued for the Chairman to signal this possibility at his last press conference and at last week’s meeting suggested that we should gird our loins to make our first move this fall. We shall see if that recommendation obtains with the majority of the Committee.

Regulatory policies can lean against emerging asset bubbles and the vulnerabilities that attend them by restraining financial institutions from excessively extending credit. In addition, such policies can build resilience in the financial system, enhancing its ability to absorb and shrug off unexpected losses from any source, including sharp asset price declines.

Of course, monetary policy also has the power to lean against the growth of asset bubbles. While there could be situations in which monetary policy might be needed to try to limit the growth of a bubble, in my opinion such use would represent a failure of regulatory policy, which represents a more tailored response than the flattening out of aggregate demand that would likely result from contractionary monetary policy.

The U.S. regulatory system is fragmented, and, hence, it takes time to choose and implement policies and calibrate them appropriately. It takes time to cooperate, coordinate, and harmonize responses. But such is today's imperative. We must complete in a timely fashion the post-Basel III and Dodd-Frank requirements. It is particularly important to increase the amount, and improve the quality, of required minimum capital; to continue stress testing and capital planning; and to reduce overreliance on unstable short-term wholesale funding. These reforms will build resilience to whatever shocks may come, and will reduce the potential for asset bubbles and excessive credit growth, leverage, maturity transformation, reliance on unstable short-term wholesale funding, and, thus, the potential for future financial crises.

Still, if regulators become fixated on the tools at the expense of compliance and enforcement, the tools themselves will be meaningless. Only when such tools--be they capital-focused, liquidity-focused, margin--and haircut-focused, or underwriting-focused--are fully embedded into a comprehensive system of prudential regulation will they reach their potential in mitigating the growth of asset bubbles and providing resiliency against the awful consequences attendant to their destruction.

ROYCE: Thank you, Mr. Chairman.

Chairman Bernanke, I think the -- the risk -- risk weighting at the end of the day is -- is only as good as the metrics that we develop. I'm thinking back to Basel I. And now we're looking at the final Basel III. The Basel III includes a risk weighting of 20 percent for debt issued by Fannie Mae and Freddie Mac. And the rule includes a risk weighting of zero for -- unconditional debt issued by Ireland, by port -- by Portugal, by Spain, by other OECD countries with no country risk classification.

Both of these risk weightings are, in my memory, identical to the risk -- risk weightings under the original Basel I. So my -- my concern is that we should have learned a few things about those metrics given the -- consequences of -- of the clear failure. And yet, here we have the accord of 1988 looking an awful lot like this particular accord. Given what we have experienced, the failure of the GSEs, the propping up of many European economies, do you think these weightings accurately reflect the actual risk posed by these exposures?

BERNANKE: So Basel III and all Basel agreements are international -- you know, international agreements. And each country can take that floor and do whatever it wants, you know, above that floor. We would not allow a U.S. bank to hold Greek debt at zero weight, I assure you.

ROYCE: Yeah.

BERNANKE: In terms of GSEs, the GSE mortgage-backed securities have not created any loss whatsoever. They have to the taxpayer, but not to the holders of those securities. So that, I don't think, has been a problem. It's not just risk weights, though. But Basel III also has significantly increased the amount of high-quality capital that banks have to hold for a given set of risk -- risky assets.

Many of the key problems related to shadow banking and their potential solutions are still being debated domestically and internationally, but some of the necessary steps are already clear.

First, we need to increase the transparency of shadow banking markets so that authorities can monitor for signs of excessive leverage and unstable maturity transformation outside regulated banks. Since the financial crisis, the ability of the Federal Reserve and other regulators to track the types of transactions that are core to shadow banking activities has improved markedly. But there remain several areas, notably involving transactions organized around an exchange of cash and securities, where gaps still exist. For example, many repurchase agreements and securities lending transactions can still only be monitored indirectly. Improved reporting in these areas would better enable regulators to detect emerging risks in the financial system.

Second, we need to reduce further the risk of runs on money market mutual funds. Late last year, the Council issued a proposed recommendation on this subject that offered three reform options. Last month, the SEC issued a proposal that includes a form of the floating net asset value (NAV) option recommended by the Council.

Third, we need to be sure that initiatives to enhance the resilience of the triparty repo market are successfully completed. These marketwide efforts have been underway for some time and have already reduced discretionary intraday credit extended by the clearing banks by approximately 25 percent. Market participants, with the active encouragement of the Federal Reserve and other supervisors, are on track to achieve the practical elimination of all such intraday credit in the triparty settlement process by the end of 2014.

Completing these three reforms would represent a strong start to the job of reducing systemic risk in the short-term wholesale funding markets that are key to the functioning of securities markets.

[E]arlier this week the federal banking agencies jointly issued a proposal to implement higher leverage ratio standards for the largest, most systemically important U.S. banking organizations. We have already finalized the rules on resolution planning and stress testing, and we are working diligently this year toward finalization of the remaining standards.

Bernanke had emerged from the June 19 meeting to say the central bank expects to reduce the pace of purchases later this year and to halt the program altogether midway through next year, when unemployment is around 7 percent, as long as the economy improves as expected.

He also sketched out the Fed's expectations for keeping rates low in the years ahead and for the even longer-term plan for shrinking the central bank's $3.4 trillion balance sheet.

"Well, that's three different parts of forward guidance," said Peter Fisher, senior director of the BlackRock Investment Institute. "I've been in this business a long time, and bond market guys aren't that clever. We can't price all that in."

As reported by Reuters.

Financial stability is a necessary prerequisite for an effective monetary policy.  There is a critical chain of linkages from monetary policy to banking and onwards to the real economy.  Financial stability is a necessary condition for those linkages to operate effectively.  Thus, it is a necessary condition for monetary policy to be able to achieve its economic objectives.  

[I]t is reasonable to ask whether systemic risks can in fact be reliably identified in advance... To respond to this point, I will distinguish, as I have elsewhere, between triggers and vulnerabilities. The triggers of any crisis are the particular events that touch off the crisis--the proximate causes, if you will. For the 2007-09 crisis, a prominent trigger was the losses suffered by holders of subprime mortgages. In contrast, the vulnerabilities associated with a crisis are preexisting features of the financial system that amplify and propagate the initial shocks. Examples of vulnerabilities include high levels of leverage, maturity transformation, interconnectedness, and complexity, all of which have the potential to magnify shocks to the financial system. Absent vulnerabilities, triggers might produce sizable losses to certain firms, investors, or asset classes but would generally not lead to full-blown financial crises

I think there's still a ways to go.  My concern, in particular, is the intersection of too-big-to-fail, our very large institutions, with very large wholesale funding markets that are subject to runs and, eventually then, to liquidity freezes.