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.

The scale and scope of the financial safety net should be matched by the scale and scope of the regulatory and supervisory regime surrounding financial institutions. The central role of prudential regulation is to constrain and prevent the excessive risk-taking that would otherwise be induced by the incentive effects of safety net support.

Let me...review in summary fashion what we regard as the key components of a legislative agenda to contain systemic risk.

First, there should be a statutory requirement for consolidated supervision of all systemically important financial firms--not just those affiliated with an insured bank as provided for under the Bank Holding Company Act of 1956 (BHC Act).

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Second, there should be a resolution regime for systemically important non-bank institutions to complement the current regime for banks under the Federal Deposit Insurance Act.

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Third, there should be clear authority for special regulatory standards--such as for capital, liquidity, and risk-management practices--applicable to systemically important firms.

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Fourth, there should be an explicit statutory requirement for analysis of the stability of the U.S. financial system.

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Fifth, additional statutory authority is needed to address the potential for systemic risk in payment and settlement systems.

Based on direct observation, I am not convinced that supervisors can consistently and effectively prevent excessive risk-taking by the large firms they oversee in a timely fashion, absent draconian measures that tend to throw out the good with the bad. For this reason, I am not confident that traditional S&R can reduce risk sufficiently such that it addresses the problems associated with TBTF status.⁶   While policymakers should improve S&R by incorporating the lessons learned over the last two years, it cannot be the bulwark in addressing TBTF.

I do see clear benefits in increasing the scope of bank-like resolution systems to entities such as bank holding companies....I have long argued that the resolution regime created by FDICIA would not, by itself, effectively limit after-the-fact protection for creditors of systemically important banks.

[F]inancial institutions are likely to have a larger global presence over time, and to be more active in financial derivatives. Both trends represent the normal outgrowth of globally integrated economies and financial markets, and are not necessarily unwelcome or unhealthy. But the critical point is that the roles and powers of supervisors and regulators have not kept up with these developments.

To be sure, a new resolution regime is not panacea. We also need better and smarter regulation. Many of the institutions that got into trouble were already heavily regulated. We didn't do enough to constrain leverage, regulate derivatives, and most important, protect the consumer. We forgot that there is a difference between "free markets", and "free for all markets".

[I]t seems plain that supervisory and regulatory policies could help prevent the kinds of problems we now face. Indeed, this was one of Minsky’s major prescriptions for mitigating financial instability. I am heartened that there is now widespread agreement among policymakers and in Congress on the need to overhaul our supervisory and regulatory system, and broad agreement on the basic elements of reform.

I expect the financial system to continue to involve a mix of capital markets and institutions, but with a wider array of institutions falling under regulatory supervision. Furthermore, I take it as given that there will continue to be large international institutions with operations in many countries, that is to say, regulatory jurisdictions around the globe.

Looking ahead, I see an ongoing role for securitization and the originate-to-distribute model. Securitization markets have shrunk dramatically over the last year and a half and in some cases have shut down altogether. I expect these markets to return, perhaps in simpler form and with more accountability.

A key point is that the systemic regulator cannot just look institution by institution, but needs to think about the potentially difficult trends emerging across a swath of interconnected institutions and their counterparties. And while it may go without saying, for a systemic regulator to be effective, the regulator needs to be able to identify whether actual systemic problems are emerging. This involves, in part, assessing the “feedback effects” that might result from initial problems.

A starting point for an effective systemic regulator would be to carefully monitor any rapid appreciation of a particular asset class, and any rapid expansion of particular financial institutions or financial markets. While rapid growth in asset prices would not in and of itself necessitate any direct actions, it should cause a systemic regulator to ask several questions.
First, can one develop a plausible fundamentals-based explanation of the rapid rise in prices?
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Second, is the rapid growth in an asset class financed by leveraged institutions?
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Third, has the rapid expansion of the financing caused any financial institutions to increase their leverage?
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Fourth, has there been a significant change in the mismatch involved in funding long-term assets with short-term liabilities?

Let me be clear that I do not think that we should rely on regulation, by itself, either at the micro- or macro-level, to prevent future crises. Markets can provide very effective discipline on the decisions of financial market participants. Any new regulatory framework should be designed to work with, and not supplant, market forces.

[T]he track record of S/R does not suggest it prevents risk-taking that seems excessive ex post. True, long shots occasionally come in, and perhaps a regime dependent on conventional S/R would succeed, but it is NCAA tournament time, and we know that a 15 seed rarely beats a number two.

It seems likely that, going forward, there will be increased emphasis on tight regulation of financial institutions and their activities, especially of large, complex, “too-big or too-interconnected-to-fail” institutions. Clearly, there will be a role for conventional supervision and regulation in the future. Observers have rightly noted that the financial sector suffers from various market failures around issues of information and misaligned incentives, and conventional supervision and regulation can help address those concerns. At the same time, we have to be careful to avoid two potentially serious pitfalls: (1) excessive reliance on conventional supervision and regulation, essentially asking more than can be delivered; and (2) excessive regulation, resulting in an inefficient financial sector with negative consequences for economic performance.

To address this will require comprehensive reform.  Not modest repairs at the margin, but new rules of the game.  The new rules must be simpler and more effectively enforced and produce a more stable system, that protects consumers and investors, that rewards innovation and that is able to adapt and evolve with changes in the financial market.

I think there is a compelling argument for some form of action to address procyclicality through policy change.  Whether that policy change should be addressed through accounting or regulatory rules is open to debate.