To strike that balance between stability and growth, we should examine what other policy weapons should be in our arsenal. Perhaps the most important are in the area of macro-prudential oversight, which we increasingly understand is an essential complement to micro-prudential supervision. Now, what exactly does macro-prudential supervision entail? To me, it means identifying and correcting behaviors and structures in financial markets that create excessive risk before they mushroom into something that threatens the entire financial system. 

Macro-prudential supervision takes a very different perspective than its micro-prudential sibling. It’s akin to caring for an entire ecosystem rather than individual trees

[T]he consolidated supervision of an individual firm, whether or not it is systemically important, is best vested with a single agency. However, the broader task of monitoring and addressing systemic risks that might arise from the interaction of different types of financial institutions and markets--both regulated and unregulated--may exceed the capacity of any individual supervisor.

In my view, redesigning regulations and improving market infrastructure offer more promising paths to increased financial stability. This is the "prevention" that forms the first line of defense in our efforts to never be in this position again. Regulation may or may not be sufficient to avoid all of the market events that help to create excessive exuberance, but it should play a very large role in controlling the existence, size, and consequences of any bubble.

Is monetary policy independence threatened by giving a central bank other responsibilities, such as supervisory and regulatory authority for some parts of the financial system? Are there potential conflicts between a high degree of independence for monetary policy and accountability in supervisory and regulatory policy? I believe that U.S. and foreign experience shows that monetary policy independence and supervisory and regulatory authority are mutually compatible and even have beneficial synergies.

Periods of market booms and other expansionary periods are precisely the times that macroprudential supervision would diverge from more traditional prudential supervision. Historically, prudential supervision has been largely reactive, becoming more activist as losses mount (or conditions otherwise deteriorate) at an institution. In contrast, a macroprudential supervisor should be particularly attuned to changes – especially dramatic ones – in such areas as leverage, asset-liability mix, or underwriting standards. This requires the macroprudential supervisor to be willing and able to “lean against the wind” during booming markets or other periods.

[A] systemic regulator should have the ability to supervise capital structure, supervise liquidity risk and asset-liability management, and supervise risk management – all to minimize the likelihood of systemically important institutions negatively impacting market functioning and economic stability, proving “contagious” to counterparties, and possibly needing government support to avoid further spreading damage or instability.

A systemic regulator or macroprudential supervisor would need not only the ability to monitor systemically important institutions, but also the ability to change behavior if firms are financing a boom by increasing leverage and liquidity risk. It follows that legislation that aims to design an effective systemic regulator needs to provide the regulator with the authority to make such changes.

Solving the boundary problem alone will not counterbalance contemporary sources of systemic risk. The rapid development of market-based financial intermediation has also highlighted the need for a macroprudential regulatory approach to complement more conventional prudential supervision.

As I envision it, one or more financial regulators would have the responsibility, accountability, and authority to identify and mitigate risks posed to the entire financial system. This means making sure that systemically important financial institutions have proper supervision, but it also means looking at possible linkages among firms and at market practices that might pose systemic risk, such as the design and distribution of asset-backed securities and the organization of the credit default swap market.

Macroprudential policies focus on risks to the financial system as a whole. Such risks may be crosscutting, affecting a number of firms and markets, or they may be concentrated in a few key areas. A macroprudential approach would complement and build on the current regulatory and supervisory structure, in which the primary focus is the safety and soundness of individual institutions and markets.

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Some commentators have proposed that the Federal Reserve take on the role of systemic risk authority; others have expressed concern that adding this responsibility would overburden the central bank. The extent to which this new responsibility might be a good match for the Federal Reserve depends a great deal on precisely how the Congress defines the role and responsibilities of the authority, as well as on how the necessary resources and expertise complement those employed by the Federal Reserve in the pursuit of its long-established core missions.

It seems to me that we should keep our minds open on these questions. We have been discussing them a good deal within the Federal Reserve System, and their importance warrants careful consideration by legislators and other policymakers. As a practical matter, however, effectively identifying and addressing systemic risks would seem to require the involvement of the Federal Reserve in some capacity, even if not in the lead role. As the central bank of the United States, the Federal Reserve has long figured prominently in the government's responses to financial crises. Indeed, the Federal Reserve was established by the Congress in 1913 largely as a means of addressing the problem of recurring financial panics.

For the Federal Reserve, adding a more explicity financial stability mandate to its existing dual mandate for price stability and economic growth raises important and difficult questions about the compatibility of these responsibilities and the problems that might arise in attempting to achieve them all simultaneously.

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I would like to focus on the following four questions as particularly important to our understanding of how financial stability fits into a central bank’s portfolio of responsibilities.

First, can we define a set of principles to guide a central bank’s mandate for financial stability?... 

Second, does a central bank have the ability to effectively pursue a tripartite mandate?...

Third, how does a central bank trade off potentially conflicting objectives under a tripartite mandate?...

 Finally, how can a central bank implement a financial stability mandate while maintaining the independence needed to actively pursue its other mandates?...

 …While there is little doubt that central banks will continue to have responsibility for financial stability going forward, recent events raise important questions about how this mandate should be implemented.

At least informally, financial regulation and supervision in the United States already include some macroprudential elements. As one illustration, many of the supervisory guidances issued by federal bank regulators have been motivated, at least in part, by concerns that a particular industry trend posed risks to the stability of the banking system as a whole, not just to individual institutions. For example, following lengthy comment periods, in 2006, the federal banking supervisors issued formal guidance on underwriting and managing the risks of nontraditional mortgages, such as interest-only and negative amortization mortgages, as well as guidance warning banks against excessive concentrations in commercial real estate lending. These guidances likely would not have been issued if the federal regulators had viewed the issues they addressed as being isolated to a few banks. The regulators were concerned not only about individual banks but also about the systemic risks associated with excessive industry-wide concentrations (of commercial real estate or nontraditional mortgages) or an industry-wide pattern of certain practices (for example, in underwriting exotic mortgages).