Well, first, Congresswoman, we're not bailing out anybody. We haven't put a penny of our money or federal money into these -- into the banks or into the CDOs.

What we are doing is exercising our responsibility to make sure that the banks disclose the information and that they value these things properly.

It's not our practice, in the broad financial world, to protect investors, particularly sophisticated investors, who should be able to make their own evaluations, from buying individual instruments.

What our responsibility is, is to make sure that the banks are safe and sound and that they are appropriately valuing their balance sheets and that their exposures to these off-balance sheet instruments are appropriately measured and accounted for, particularly with respect to capitals.

From the Q&A session

Given the substantial number of resets from now through the end of 2008, however, I believe it would behoove the industry to join together and explore collaborative, creative efforts to develop prudent loan modification programs and other assistance to help large groups of borrowers systematically.

Second, I believe that modernization of programs administered by the Federal Housing Administration, which has considerable experience helping low- and moderate-income households obtain home financing, could also help avoid foreclosures. FHA modernization could give the agency the flexibility to work with private-sector lenders to expedite the refinancing of creditworthy subprime borrowers and to design products that improve affordability through such features as variable maturities or shared appreciation.

Third, we must pursue initiatives to prevent these problems from recurring, and the Federal Reserve is making strides in this direction. ... For example, as I mentioned earlier, failure to escrow for taxes and insurance can lead to a situation akin to payment shock for borrowers. It is a common practice for these payments to be escrowed in the prime markets, and I see no reason that escrows should not be standard practice in the subprime markets too.

The safety and soundness of the U.S. banking and payments systems is critical to achieving economic growth, maximum employment, and general economic stability, and the Federal Reserve works closely with other regulators to achieve this goal. The Federal Reserve also has an important role to play in responding to and mitigating the impact of financial crises and shocks. If confirmed, I would continue to work vigorously to protect and promote the safety and soundness of the system.

We need to be more attentive to the risk that specific aspects of our system, regulations or other constraints, create a greater disincentive to locate a financial business here, or to invest here, or to raise capital here, than would have been the case five or ten years ago. We need to take a careful look at how we regulate financial activity in a world where capital is more mobile, and the structure of the financial system has diverged substantially from the system for which our regulatory framework was designed.

The Board believes that the "Principles and Guidelines Regarding Private Pools of Capital" issued by the President's Working Group on Financial Markets (PWG) in February provides a sound framework for addressing these challenges associated with hedge funds, including the potential for systemic risk.¹ The Board shares the considered judgment of the PWG: the most effective mechanism for limiting systemic risks from hedge funds is market discipline; and, the most important providers of market discipline are the large, global commercial and investment banks that are their principal creditors and counterparties.

At the Federal Reserve, the Board of Governors is carefully considering how it might further use its rulemaking authority under the Home Ownership Equity Protection Act to curb abusive lending practices without discouraging responsible subprime lending.

More complex pricing and continuous change in the marketplace make the task of writing rules for effective disclosure challenging. Nevertheless, the combination of extensive review, substantial public input, and systematic consumer testing has enabled us to propose changes that we believe will further the original goals of the Truth in Lending Act to promote economic stability and competition through the informed use of credit.

In thinking about how, or whether, to regulate innovative financial institutions (such as hedge funds) or instruments (such as credit derivatives), we should be wary of drawing artificial distinctions. Are the characteristics of hedge funds or credit derivatives that arouse concern peculiar to these institutions and instruments, or are they associated with others as well? If the characteristics in question are in fact a feature of the broader financial landscape, then a narrowly focused approach to regulation will be undermined by the incentives such an approach creates for regulatory arbitrage.

For example, while the complexity of new financial instruments and trading strategies is potentially a concern for policy, as I will discuss, not all credit derivatives are complex and--to state the obvious--not all complex financial instruments are linked to credit risk. Single-name credit default swaps and credit default swap indexes are relatively simple instruments, whereas derivatives based on other asset classes--such as exotic interest-rate and foreign-exchange options--can, by contrast, be quite complex. Moreover, derivatives in general are not necessarily more complex than some types of structured securities. In short, if complexity per se is the concern, we cannot address that concern by focusing on a single class of financial instruments. Similarly, hedge funds are hardly a homogeneous group of institutions, nor can their trading strategies be unambiguously distinguished from those of large global banks or of some traditional asset managers. A consistent regulatory strategy needs to be tailored to the essential characteristics of institutions or instruments that pose risks for policy objectives, not to arbitrary categories.

Some commentators have sought to draw a sharp distinction between the approach to financial regulation in the United States and that in the United Kingdom. These observers have characterized the British approach as being principles-based and as using a "light touch"--the implication being that these two features somehow go together. In a speech in February of this year, Sir Callum McCarthy, the head of the United Kingdom's Financial Services Authority (FSA), took issue with this interpretation.¹ Sir Callum confirmed that the FSA's approach is built on a framework of principles, although he noted that the FSA also has an 8,500-page rulebook to accompany the eleven principles it has laid out. But the FSA head rejected the view that their approach is "light touch." Rather, he said, it is risk-based, which means that regulatory resources and attention are devoted to firms, markets, or instruments in proportion to the perceived risks to the FSA's regulatory objectives.

...I have argued today that we should strive to implement a regulatory regime that is principles-based, risk-focused, and consistently applied. Enhancing market discipline can complement and strengthen such an approach. As in the United Kingdom, a principles-based approach is not inconsistent with the use of rules, which can provide needed clarity or a safe haven from legal and regulatory risks. However, rules should implement principles rather than develop in an ad hoc manner.

I have argued today that, in many situations, regulation that relies on the invisible hand of market-based incentives can complement direct government regulation.  For market-based regulation to work, the incentives of investors and other private actors must align with the objectives of the government regulator.  In particular, private investors must be sophisticated enough to understand and monitor the financial condition of the firm and be persuaded that they will experience significant losses in the event of a failure.  When these conditions are met, market discipline is a powerful and proven tool for constraining excessive risk-taking.  

The information, expertise, and powers that the Fed derives from its supervisory authority enhance its ability to contribute to efforts to prevent financial crises; and, when financial stresses emerge and public action is warranted, the Fed is able to respond more quickly, more effectively, and in a more informed way than would otherwise be possible.

Finally, when innovation occurs outside of the banking industry, regulators' main concern should be with the interactions between the regulated and unregulated sectors. For example, supervisors and institutions have focused heavily in recent years on strengthening counterparty risk management practices and the settlement infrastructures undergirding important new financial markets. As I noted earlier, supervising this boundary requires that regulators broadly understand the activities of the unregulated sector, but perhaps even more important, it also requires regulators to understand how innovations change the ways in which exposures can flow back into the banking sector.

Good regulatory and supervisory policies should implement congressional intent in ways that maximize social benefits and minimize social costs. The regulatory burden on banks is not the only element of social cost, but it is an important component. Accordingly, in developing regulatory and supervisory policies, the Federal Reserve and the other banking agencies will continue to pay close attention to the implications of those policies for regulatory burden, competitiveness, and efficiency in banking.

I should briefly reiterate my concerns about the safety net for the creditors of the largest banks, as these concerns shape my views on the ILC issue. As I have noted before, I worry that some of these creditors believe they will be bailed out in the event of institutional insolvency because their bank is viewed as “too big to fail.”

But because I believe we should strive to limit protection for creditors of large banks, additional combinations of banks and nonbanking firms that potentially expand the safety net to cover activities not currently in scope are particularly troubling. As a matter of public policy, it would be far preferable from my perspective to take steps to limit the existing safety net.

In addition to enhancing the meaningfulness of regulatory capital measures, Basel II should make the financial system safer by substantially improving risk management at banks.