I should note at the outset that solving the TBTF [Too Big to Fail] problem has two distinct aspects. First, and most obviously, one goal is to get to the point where all market participants understand with certainty that if a large SIFI [Systemically Important Financial Institution] were to fail, the losses would fall on its shareholders and creditors, and taxpayers would have no exposure. However, this is only a necessary condition for success, but not a sufficient one. A second aim is that the failure of a SIFI must not impose significant spillovers on the rest of the financial system, in the form of contagion effects, fire sales, widespread credit crunches, and the like. Clearly, these two goals are closely related. If policy does a better job of mitigating spillovers, it becomes more credible to claim that a SIFI will be allowed to fail without government bailout.

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Still, we are quite a way from having fully solved the policy problems associated with SIFIs. For one thing, the market still appears to attach some probability to the government bailing out the creditors of a SIFI; this can be seen in the ratings uplift granted to large banks based on the ratings agencies' assessment of the probability of government support. While this uplift seems to have shrunk to some degree since the passage of Dodd-Frank, it is still significant. All else equal, this uplift confers a funding subsidy to the largest financial firms.

Moreover, as I noted earlier, even if bailouts were commonly understood to be a zero-probability event, the problem of spillovers remains. It is one thing to believe that a SIFI will be allowed to fail without government support; it is another to believe that such failure will not inflict significant damage on other parts of the financial system. In the presence of such externalities, financial firms may still have excessive private incentives to remain big, complicated, and interconnected, because they reap any benefits--for example, in terms of economies of scale and scope--but don't bear all the social costs.

How can we do better? Some have argued that the current policy path is not working, and that we need to take a fundamentally different approach. Such an alternative approach might include, for example, outright caps on the size of individual banks, or a return to Glass-Steagall-type activity limits.

My own view is somewhat different. While I agree that we have a long way to go, I believe that the way to get there is not by abandoning the current reform agenda, but rather by sticking to its broad contours and ratcheting up its forcefulness on a number of dimensions. In this spirit, two ideas merit consideration: (1) an increase in the slope of the capital-surcharge schedule that is applied to large complex firms, and (2) the imposition at the holding company level of a substantial senior debt requirement to facilitate resolution under Title II of Dodd-Frank. In parallel with the approach to capital surcharges, a senior debt requirement could also potentially be made a function of an institution's systemic footprint.

Let me briefly mention another piece of the puzzle that I think is sometimes overlooked, but strikes me as having the potential to play an important complementary role in efforts to address the TBTF problem--namely, corporate governance. Suppose we do everything right with respect to capital regulation, and set up a system of capital surcharges that imposes a strong incentive to shrink on those institutions that don't create large synergies. How would the adjustment process actually play out? The first step would be for shareholders, seeing an inadequate return on capital, to sell their shares, driving the bank's stock price down. And the second step would be for management, seeking to restore shareholder value, to respond by selectively shedding assets.

But as decades of research in corporate finance have taught us, we shouldn't take the second step for granted. Numerous studies across a wide range of industries have documented how difficult it is for managers to voluntarily downsize their firms, even when the stock market is sending a clear signal that downsizing would be in the interests of outside shareholders. Often, change of this sort requires the application of some external force, be it from the market for corporate control, an activist investor, or a strong and independent board. As we move forward, we should keep these governance mechanisms in mind, and do what we can to ensure that they support the broader regulatory strategy.

The Fed vice chairman said the central bank’s low-rate policies are intended “to promote a return to prudent risk-taking” in credit markets. “Obviously, risk-taking can go too far,” Yellen said today at an International Monetary Fund panel discussion on monetary policy in Washington.

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“I don’t see pervasive evidence of rapid credit growth, a marked buildup in leverage, or significant asset bubbles that would threaten financial stability,” Yellen said. “But there are signs that some parties are reaching for yield, and the Federal Reserve continues to carefully monitor this situation.”

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The Fed vice chairman said in her remarks that she was “persuaded” by Columbia University economist Michael Woodford’s theories that keeping interest rates “lower for longer” are suitable for times of high unemployment and weak demand. The FOMC’s decision to tie the benchmark interest rate to economic indicators aligns with the “lower for longer” approach, she said.

As reported by Bloomberg Businessweek

But I do want to spend a moment on one potential cost--financial stability--because this topic returns us to the theme of "many targets" for central banks. As Chairman Bernanke has observed, in the years before the crisis, financial stability became a "junior partner" in the monetary policy process, in contrast with its traditionally larger role. The greater focus on financial stability is probably the largest shift in central bank objectives wrought by the crisis.

Some have asked whether the extraordinary accommodation being provided in response to the financial crisis may itself tend to generate new financial stability risks. This is a very important question. To put it in context, let's remember that the Federal Reserve's policies are intended to promote a return to prudent risk-taking, reflecting a normalization of credit markets that is essential to a healthy economy. Obviously, risk-taking can go too far. Low interest rates may induce investors to take on too much leverage and reach too aggressively for yield. I don't see pervasive evidence of rapid credit growth, a marked buildup in leverage, or significant asset bubbles that would threaten financial stability. But there are signs that some parties are reaching for yield, and the Federal Reserve continues to carefully monitor this situation.

However, I think most central bankers view monetary policy as a blunt tool for addressing financial stability concerns and many probably share my own strong preference to rely on micro- and macroprudential supervision and regulation as the main line of defense. The Federal Reserve has been working with a number of federal agencies and international bodies since the crisis to implement a broad range of reforms to enhance our monitoring, mitigate systemic risk, and generally improve the resilience of the financial system. Significant work will be needed to implement these reforms, and vulnerabilities still remain. Thus, we are prepared to use any of our many instruments as appropriate to address any stability concerns.

Over time, we expect banks to better understand the basic elements of the supervisory models, rendering them at least somewhat less opaque.

At the same time, it is reasonable to worry that, with increased disclosure of supervisory models, firms would see a declining benefit to maintaining independent risk-management systems and would just adopt supervisory models instead. Doing so would certainly make it easier to "pass" the stress tests. However, all models have their blind spots, and such an outcome risks a "model monoculture" that would be susceptible to a single, common failure. The differences in stress test results obtained by supervisors' and banks' own models can be informative, and we do not want inadvertently to destroy the healthy diversity or innovation of the models and other risk-management tools used in the banking industry.

[A]s we learned from this most recent crisis, emerging risks can be hard to judge and it can be even harder to determine what action should be taken ahead of any obvious or near-term threat. In addition, riskier financial activity can grow outside the regulated sector. For these reasons, asking bank regulators and supervisors, or the newly-tasked monitors of financial stability, to single-handedly identify and contain the risks introduced by a highly accommodative monetary policy is not realistic.

For these reasons, it can be useful to gauge our purchases both relative to gross issuance as well as the amount of outstanding stock that can likely be delivered into the Desk’s TBA purchases. Since the current purchase program began, the Desk’s purchases have accounted for about 50 percent of gross issuance on average, below the average monthly purchase rate of roughly two-thirds during the first round of large-scale MBS purchases in 2009. If refinancing activity declines, leading to a decrease in gross issuance, our purchases could exceed these levels. Such higher levels still seem unlikely to cause significant market functioning issues, given the considerable supply of existing stock that we believe could be delivered into the Desk’s TBA purchases over time. Nevertheless, not all new securities are issued in the TBA market, and it is difficult to estimate future gross issuance, so the Desk monitors the purchasable supply of MBS closely.

While the Federal Reserve’s accommodative monetary policy has been an important driver of the current economic recovery, and the financial stability costs appear relatively modest at this time, we cannot be Pollyannas. There are areas that we should closely monitor. Some areas that bear watching, in my view, are specific markets where underwriting standards are slipping – or where rapid growth in financial products could become a more significant concern.

In terms of underwriting standards, the covenant quality on new high-yield bond issuance should be closely monitored…

Also, financial structures that involve the use of short-term borrowing to finance longer-term assets should be monitored carefully. For example, agency real estate investment trusts (agency REITS) have grown rapidly, involve leverage, and are susceptible to sharp interest rate movements…

Finally, many non-depository financial institutions that were susceptible to runs during the financial crisis still have not resolved that run risk. For example, money market mutual funds experienced a severe run requiring substantial government intervention during the crisis, yet the regulatory reform effort is moving only slowly. Similarly, Federal Reserve Governor Daniel Tarullo and New York Fed President William Dudley have raised concerns about broker-dealers and wholesale funding markets...

Of course, heavy capital inflows and their volatility pose challenges to emerging market policymakers, whatever their source. Policymakers do have some tools to address these concerns. In recent years, emerging market nations have implemented macroprudential measures aimed at strengthening their financial systems and reducing overheating in specific sectors, such as property markets. Policymakers have also experimented with various forms of capital controls. Such controls raise concerns about effectiveness, cost of implementation, and possible microeconomic distortions. Nevertheless, the International Monetary Fund has suggested that, in carefully circumscribed circumstances, capital controls may be a useful tool.

While some of the more notorious pre-crisis components of the shadow banking system are probably gone forever, current examples include money market funds, the triparty repo market, and securities lending.

From the perspective of financial stability, the parts of the shadow banking system of most concern are those that create assets thought to be safe, short-term, and liquid--in effect, cash equivalents. For a variety of reasons, demand for such assets has grown steadily in recent years, and is not likely to reverse direction in the foreseeable future. Yet these are the assets whose funding is most likely to run in periods of stress, as investors realize that their resemblance to cash or insured deposits in normal times has disappeared in the face of uncertainty about their underlying value.

In the wake of the crisis, we need to consider carefully the view that central banks should assess the effect of monetary policy on financial stability and, in some instances, adjust their policy decisions to take account of these effects…

It is important to note that incorporating financial stability considerations into monetary policy decisions need not imply the creation of an additional mandate for monetary policy. The potentially huge effect on price stability and employment associated with bouts of serious financial instability gives ample justification.

Here I want to mention some comments by my colleague Jeremy Stein a couple of weeks ago. After reviewing the traditional arguments against using monetary policy in response to financial stability concerns and relying instead on supervisory policies, Governor Stein offered several reasons for keeping a more open mind on the subject…[B]y altering the composition of its balance sheet, central banks may have a second policy instrument in addition to changing the targeted interest rate. So, for example, it is possible that a central bank might under some conditions want to use a combination of the two instruments to respond to concurrent concerns about macroeconomic sluggishness and excessive maturity transformation by lowering the target (short-term) interest rate and simultaneously flattening the yield curve through swapping shorter duration assets for longer-term ones.

It is sometimes argued that … policymakers should follow what might be called a decoupling approach. That is, monetary policy should restrict its attention to the dual mandate goals of price stability and maximum employment, while the full battery of supervisory and regulatory tools should be used to safeguard financial stability. There are several arguments in favor of this approach. First, monetary policy can be a blunt tool for dealing with financial stability concerns…

A related concern is that monetary policy already has its hands full with the dual mandate, and that if it is also made partially responsible for financial stability, it will have more objectives than instruments at its disposal and won't do as well with any of its tasks…

Nevertheless, as we move forward, I believe it will be important to keep an open mind and avoid adhering to the decoupling philosophy too rigidly. In spite of the caveats I just described, I can imagine situations where it might make sense to enlist monetary policy tools in the pursuit of financial stability. Let me offer three observations in support of this perspective. First, despite much recent progress, supervisory and regulatory tools remain imperfect in their ability to promptly address many sorts of financial stability concerns...

Second, while monetary policy may not be quite the right tool for the job, it has one important advantage relative to supervision and regulation--namely that it gets in all of the cracks. The one thing that a commercial bank, a broker-dealer, an offshore hedge fund, and a special purpose ABCP vehicle have in common is that they all face the same set of market interest rates. To the extent that market rates exert an influence on risk appetite, or on the incentives to engage in maturity transformation, changes in rates may reach into corners of the market that supervision and regulation cannot.

Third, in response to concerns about numbers of instruments, we have seen in recent years that the monetary policy toolkit consists of more than just a single instrument…

One of the most difficult jobs that central banks face is in dealing with episodes of credit market overheating that pose a potential threat to financial stability. We ought to be open-minded in thinking about how to best use the full array of instruments at our disposal. Indeed, in some cases, it may be that the only way to achieve a meaningfully macroprudential approach to financial stability is by allowing for some greater overlap in the goals of monetary policy and regulation.

Turning next to the issue of money market mutual funds, further reform to directly address the incentive for investors to run is essential for financial stability.

In November, the Financial Stability Oversight Council (FSOC) put out for comment three alternative paths forward:13

1. Moving to a floating net asset value (NAV).
2. Retaining a stable NAV, but adding a new NAV buffer and a minimum balance requirement. The minimum balance would be at risk for 30 days following withdrawals. If the fund subsequently “broke the buck” during this period by suffering losses greater than the size of its NAV buffer, the minimum balance would be first in line to absorb these losses.
3. A larger NAV buffer than in the second alternative, but without a minimum balance at risk buffer.

I have stated my views on money fund reform before. Although any of these proposals—depending on the fine print of course—would likely be an improvement over the status quo, the first and third proposals don’t fully eliminate the incentives to run. In the case of a floating rate NAV, fund managers faced with large redemption requests typically sell their most liquid assets first, leaving the remaining investors with a riskier, less-liquid portfolio and a greater risk of loss. Similarly, with a stable NAV and a capital buffer, unless the capital buffer were very large, there would still be an incentive to run because the buffer might not prove large enough to shield the investor from loss.

Because the second option is the only one that actually creates a disincentive to run, as I stated before the FSOC proposal, I view it as the best one for financial stability purposes.

"We need some substantial improvement" in the jobless rate to consider a major shift in the Fed's purchases of Treasury and mortgage debt, Federal Reserve Bank of Boston President Eric Rosengren said in an interview with Dow Jones Newswires.

Compared to the current 7.8% unemployment rate, the official said once a 7 1/4% rate is achieved, central bankers would need to have a "full discussion" about the utility of pressing forward with bond buying.

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Mr. Rosengren also said in the interview he doesn't believe the Fed's very aggressive policy is creating new financial market imbalances.

"I am not seeing strong evidence there is collateral damage" from Fed actions, and "I'm not seeing anything more generally that would pose a macroeconomic concern at this time." For those who believe historic low yields in the bond market represent a bubble, Mr. Rosengren said "the lower interest rates are exactly what we intended on doing," adding "these rates won't stay in place" forever.