The ultimate responsibility for risk identification and risk management remains with the supervised institution. The Federal Reserve’s role is to ensure that the institution has the necessary strong processes in place to achieve this objective. As risks emerge, supervisors intervene, within the realms of their safety and soundness mandates, to require that banks take corrective actions as necessary. Supervision can reduce the chance that a financial firm fails, but it can never provide a guarantee against failure.

Taken together, we have made considerable progress in terms of the global regulatory regime to reflect the growing importance of FMIs and central counterparties (CCPs) within the financial system.

Let me briefly list a few of the accomplishments of the PFMI:
• They are now being globally adopted and implemented as mandatory, and the specific requirements themselves have been raised substantially. For example, there is a new, explicit liquidity standard to ensure that payments are made on time and in the right currency, and the cover 2 requirement for complex CCPs is much tougher than what came before it.
• They also provide greater detail and scope, including more detailed guidance with respect to CCPs and trade repositories (TRs).
• They are underpinned by a detailed disclosure framework, an agreed assessment methodology and a rigorous monitoring program to both promote consistency in how authorities have adopted and implemented the PFMI as well as, importantly, to promote consistency in outcomes.
• They provide greater harmonization to avoid regulatory arbitrage and race to the bottom behaviors.
• They include requirements and guidance for FMIs to implement their own viable recovery and orderly wind-down plans.

As I see it, great progress has been made, but there is more work to do in a number of areas:
• Greater harmonization and better cross-border mutual recognition practices;
• CCP recovery and resilience as well as coordination with other authorities to ensure incentives are aligned;
• Appropriate incentives for CCPs so that the profit motive does not conflict with having a safe system that can absorb large shocks without destabilizing the financial system; and
• Availability of data in TRs on a cross-border basis to facilitate the development of a more complete picture of market activities and emerging risks.

For that reason, I believe community banks have a vested interest in seeing that regulatory reforms move ahead to ensure that the largest banks are well capitalized, well supervised, well managed and subject to failure. Achieving that end will serve the public well. While that work is underway, regulators must also allow examiner judgment and common sense to play a greater role in their supervisory regimes for community banks.

I'm often told that the world has become more complicated, that we have too many banks in the U.S. and that we cannot go back to less-complex and more-straightforward regulation and rules and greater supervisory judgment. I'm not convinced. One of the best responses to that assertion was from Sir Mervyn King, the former governor of the Bank of England. Although his reference was made in the context of finding a solution to the issue of too big to fail, the same might be said for addressing the regulatory environment more generally. He said, There are those who claim that such proposals are impractical. It is hard to see why. What does seem impractical, however, are the current arrangements.

There are many models of regulatory coordination, but I shall focus on only two: the British and the American. As is well known, the United Kingdom has reformed financial sector regulation and supervision by setting up a Financial Policy Committee (FPC), located in the Bank of England; the major reforms in the United States were introduced through the Dodd-Frank Act, which set up a coordinating committee among the major regulators, the Financial Stability Oversight Council (FSOC).

In discussing these two approaches, I draw on a recent speech by the person best able to speak about the two systems from close-up, Don Kohn. Kohn sets out the following requirements for successful macroprudential supervision: to be able to identify risks to financial stability, to be willing and able to act on these risks in a timely fashion, to be able to interact productively with the microprudential and monetary policy authorities, and to weigh the costs and benefits of proposed actions appropriately. Kohn's cautiously stated bottom line is that the FPC is well structured to meet these requirements, and that the FSOC is not. In particular, the FPC has the legal power to impose policy changes on regulators, and the FSOC does not, for it is mostly a coordinating body.

After reviewing the structure of the FSOC, Kohn presents a series of suggestions to strengthen its powers and its independence. The first is that every regulatory institution represented in the FSOC should have the goal of financial stability added to its mandate. His final suggestion is, "Give the more independent FSOC tools it can use more expeditiously to address systemic risks." He does not go so far as to suggest the FSOC be empowered to instruct regulators to implement measures somehow decided upon by the FSOC, but he does want to extend its ability to make recommendations on a regular basis, perhaps on an expedited "comply-or-explain" basis.

Given the rescue expectations that have built up over the last several decades, I believe it will take more than a sincere pledge to limit central bank lending to solve the time consistency problem. The resolution planning provisions of the Dodd-Frank Act — often called “living wills” — require the creation of credible plans for resolving large institutions in bankruptcy without government funding. Work is underway implementing these provisions, but much more is needed. It’s worth emphasizing, however, that such plans should not take the current complexity and scale of large institutions as immutably given. The strategy should be to work backward from resolvability, without government funding backstops, to deduce how their current operations and funding need to be structured. Significant changes may be required, but resolution planning appears to be the only plausible way to dismantle “too big to fail.”

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.

Given the centrality of strong capital standards, a top priority this year will be to update the bank regulatory capital framework with a final rule implementing Basel III and the updated rules for standardized risk-weighted capital requirements… I think there is a widespread view that the proposed rule erred on the side of too much complexity…

The Federal Reserve also intends to work this year toward finalization of its proposals to implement the enhanced prudential standards and early remediation requirements for large banking firms... Once finalized, these comprehensive standards will represent a core part of the new regulatory framework that mitigates risks posed by systemically important financial firms and offsets any benefits that these firms may gain from being perceived as "too big to fail."

We also anticipate issuing notices of some important proposed rulemakings this year. The Federal Reserve will be working to propose a risk-based capital surcharge applicable to systemically important banking firms. This rulemaking will implement for U.S. firms the approach to a systemic surcharge developed by the Basel Committee, which varies in magnitude based on the measure of each firm's systemic footprint...

Another proposed rulemaking will cover implementation by the three federal banking agencies of the recently completed Basel III quantitative liquidity requirements for large global banks. The financial crisis exposed defects in the liquidity risk management of large financial firms, especially those which relied heavily on short-term wholesale funding. These new requirements include the liquidity coverage ratio (LCR), which is designed to ensure that a firm has a sufficient amount of high quality liquid assets to withstand a severe standardized liquidity shock over a 30-day period…

I think there is a widespread view that the proposed {Basel III} rule erred on the side of too much complexity.

Today, although some of the most fragile investment vehicles and instruments that were involved in the pre-crisis shadow banking system have disappeared, non-deposit short-term funding remains significant. In some instances it involves prudentially regulated firms, directly or indirectly. In others it does not. The key condition of the so-called "shadow banking system" that makes it of systemic concern is its susceptibility to destabilizing funding runs, something that is more likely when the recipients of the short-term funding are highly leveraged, engage in substantial maturity transformation, or both…

First, the regulatory and public transparency of shadow banking markets, especially securities financing transactions, should be increased. Second, additional measures should be taken to reduce the risk of runs on money market mutual funds. The Council recently proposed a set of serious reform options to address the structural vulnerabilities in money market mutual funds.

Third, we should continue to push the private sector to reduce the risks in the settlement process for tri-party repurchase agreements. Although an industry-led task force made some progress on these issues, the Federal Reserve concluded that important problems were not likely to be successfully addressed in this process and has been using supervisory authority over the past year to press for further and faster action by the clearing banks and the dealer affiliates of bank holding companies.

Without commenting on the specifics of any of these individual regulatory rules under consideration, I think it is important to note that potentially each of them--servicing requirements, capital requirements, and underwriting requirements--will affect the costs and liabilities associated with mortgage lending and thus the attractiveness of the mortgage lending business. The Federal Reserve is aware of this situation and will apply its best judgment to weigh the cost and availability of credit against consumer protection, investor clarity, and financial stability as it writes rules that are consistent with the statutory provisions that require those rules. But regardless of what the final contours of the rules are, I think the mortgage market will benefit from having them decided so that business models can be set and investments calibrated.

Almost by definition, prudential reforms are injunctions to firms or markets about what they should not do. Even affirmatively stated requirements to maintain specified capital ratios can be understood as prohibitions upon extending more credit, purchasing another instrument, or distributing a dividend unless the minimum ratio would be maintained. Prohibition and constraint are quite appropriately at the center of a regulatory system. Yet the policies that underlie regulation should embody a more affirmative set of social goals

Finance and financial intermediation are not ends in themselves, but means for pursuing savings, investment, and consumption goals. Our debate about what we don't want intermediaries and financial markets doing must be informed by a better articulated view of what we do want them doing.

Moreover, as time passes, memories fade, and the financial system normalizes, it seems likely that new forms of shadow banking will emerge. Indeed, the increased regulation of the major securities firms may well encourage the migration of some parts of the shadow banking system further into the darkness--that is, into largely unregulated markets.

[Despite provisions in the Dodd-Frank bill,] the FDIC retains considerable discretion in the use of funds to limit losses to some creditors, and the Treasury can invoke orderly resolution for firms that have not been subject to enhanced regulation. The Fed also retains some discretionary power to lend to non-bank entities. This creates continued uncertainty about possible rescues, as well as gaps in our ability to provide clear, credible constraints on the safety net.

I think it is underappreciated how important harmonization is to ensure success of the global regulatory reform effort. Without harmonized standards, financial intermediation would inevitably move toward geographies and activities where the standards are more lax.  This, in turn, would provoke complaints from those who cannot make such adjustments as easily. The political process, in turn, would be sensitive to such complaints, creating pressure for liberalization, which would cause the tougher standards to unravel over time...

...There is understandable and genuine concern that the impact of moving to global standards will fall disproportionately on some types of firms. In my view, the way to mitigate these issues is to have a long phase-in period in the transition to the new standards rather than to soften or alter the standards to shelter those firms that happen—perhaps by historical accident—to be starting in a less advantageous position. The focus should be more on the side of all ending up in a similar place, rather than on the relative degree of difficulty in getting there.

The process is also fragile because some countries seem intent on strengthening their own set of standards before the international process has had a chance to reach consensus. Although it is understandable that countries would want to move quickly to strengthen their regulatory regimes, such actions should not be undertaken in a way that is immutable and unresponsive to the emerging international consensus.¹

Legislative change is needed to ensure that systemically important financial firms are subject to effective consolidated supervision, whether or not the firm owns a bank.