Observers have rightly noted that the financial sector suffers from various market failures around issues of information and misaligned incentives, and 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 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.

The challenge for regulators and other authorities is to create an environment that supports greater bank intermediation, which should help to restore the health of the financial system and the economy. We want banks to be willing to deploy capital and liquidity, but they must do so in a responsible way that avoids past mistakes and does not create new ones.

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The events of the past year and a half have highlighted the need for changes in our financial system. Presumably, such changes may include a different balance between bank-based and market-based financial intermediation. As regulators of banks and thrifts, our job is not to determine what this balance should be. Rather, our job is, and has been, to create an environment in which, in the short run, banks can step up to fill as much of the gap as possible that has been left by still-dysfunctional markets, consistent with a strong, stable banking system. Over time, of course, we will need to work with the Congress and the new Administration to construct a system of oversight over both markets and institutions that better protects the stability of the financial system and the U.S. economy.

One of the most obvious observations from the current turmoil is that a crisis can stem from parts of the financial market not covered by traditional safety nets.  In past crises, we have typically been able to direct our efforts toward banks and other depository institutions where we have safety nets and a supervisory and regulatory framework to address institutional problems and restore market confidence.  However, many of the institutions and markets now under stress are not subject to prudential oversight.

This expansion of the scope and scale of Fed lending may not have been so large had we had better resolution mechanisms to deal with such failing firms as Bear Stearns and AIG. And perhaps our lending would not have become so wide-ranging had there been better regulation or more resiliency in the payment and settlement systems, including more transparency about the markets for mortgage-backed securities and credit default swaps.
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Some may think access to the Fed's lending facilities should be permanently expanded to include a wide range of financial institutions. I believe such expanded access to central bank credit would raise significant issues of moral hazard that would need to be addressed. And I have urged that we must continue to avoid compromising the Fed's independence — one of the great strengths of central banks.

Some people might think that expanding the Federal Reserve's regulatory and supervisory authority and giving it a sweeping mandate for financial stability would prevent the types of financial crises we have been experiencing this year. That is unrealistic.

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Going forward our focus should be on better regulation, not necessarily more regulation. We need to focus on ways to strengthen our financial markets to make market discipline more effective at mitigating systemic risk. We should think about which financial markets are critical to the efficient functioning of the payment system rather than focusing on individual firms. Ideally, we need to determine which aspects of the financial system are critical and then make sure we have the market mechanisms, regulations, and supervision to ensure those sectors are resilient.

Over the past year, there have been a number of suggestions for possible statutory changes in U.S. financial services regulation, so bank directors must be prepared for whichever outcomes such changes might imply for the regulatory structure in the United States. For example, the Congress may wish to undertake legislative action to effect regulatory changes, or there may be changes to the existing authority and responsibility of certain regulatory bodies. In any event, there will likely be some type of adjustments in regulatory structure simply given the changes in the financial services landscape. Given the fluid situation in which we find ourselves today, bank directors and senior management in their strategic planning have to anticipate a range of potential outcomes in the regulatory sphere in both the short and long term.

An effective means of increasing the resilience of the financial system is to strengthen its infrastructure. For my purposes today, I want to construe "financial infrastructure" very broadly, to include not only the "hardware" components of that infrastructure--the physical systems on which market participants rely for the quick and accurate execution, clearing, and settlement of transactions--but also the associated "software," including the statutory, regulatory, and contractual frameworks and the business practices that govern the actions and obligations of market participants on both sides of each transaction.

From a regulatory and supervisory perspective, the investment banks and the other primary dealers raise some distinct issues. First, as I noted, neither the firms nor the regulators anticipated the possibility that investment banks would lose access to secured financing, as Bear Stearns did. Second, in the absence of countervailing regulatory measures, the Fed's decision to lend to primary dealers--although it was necessary to avoid serious financial disruptions--could tend to make market discipline less effective in the future. Going forward, the regulation and supervision of these institutions must take account of these realities. At the same time, reforms in the oversight of these firms must recognize the distinctive features of investment banking and take care neither to unduly inhibit efficiency and innovation nor to induce a migration of risk-taking activities to institutions that are less regulated or beyond our borders.

One of the central objectives in reforming our regulatory framework should be to mitigate the fragility of the system and to reduce the need for official intervention in the future. I know that many hope and believe that we could design our system so that supervisors would have the ability to act preemptively to diffuse pockets of risk and leverage. I do not believe that is a desirable or realistic ambition for policy. It would fail, and the attempt would entail a level of regulation and uncertainty about the rules of the game that would offset any possible benefit. I do believe, however, that we can make the system better able to handle failure by making the shock absorbers stronger.    

We have taken some very strong steps to make sure that people have flexibilty thats necessary to deal with re-financing, to deal with the potential payment shock that can come from an interest rate reset.

From Q&A as reported by Market News International

This is an important and extremely valuable time to be thinking on what is the best role for individual (financial) regulators; how can we best go forward and have the most effective regulatory system. 

I think certainly the supervision and regulation function that we (the Fed) have has been very important in providing us with the information and the expertise to be able to understand financial market developments and respond quickly both to individual institutions and more broadly to market developments.

From Q&A as reported by Market News International

Recent events will very likely initiate a new round of financial reforms.

No doubt some of these efforts have been appropriate. In other cases, there may have been some regulatory overshoot -- new rules doing as much or more harm than good.

The repeal of Glass-Steagall didn't contribute to financial turmoil in a way that we should roll it back.

From audience Q&A as reported by Market News International and Bloomberg News

We have to find a better balance between market discipline and regulation in our financial system, a better balance between efficiency and innovation and reserves and stability.
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The best defence is to make sure you get the incentives right so that financial institutions hold larger cushions, larger shock absorbers, in good times, against conditions of stress. Hard to do, complicated to figure out how to do it well - but that's the critical objective.

As reported by Reuters

In sum, understanding banks is critical to understanding how financial shocks can be transmitted to the real economy. Unfortunately, understanding how banks are likely to respond to problems requires far more than published financial statements. While U.S. banks report detailed information on their balance sheets and their income statements, these reports do not provide sufficient information to allow central banks to really discern how banks are responding to problems.

As financial markets have changed, it's appropriate for us to step back and review whether the regulatory structure we have in place is keeping pace with the changes that are occurring in financial markets.

From audience Q&A, as reported by Market News International and Reuters.