We should distinguish between systemic risk and market risk. The risks to investors generally represent market risk and do not appear to pose risks to the financial system as a whole. The movement of these risks away from the nation's most systemically important financial institutions is one of many reasons that they are far stronger and more resilient than before the crisis.

There is a ring of truth to the idea that low interest rates might be acting as life support for companies that are destined to fail. The flip side of that coin, however, is that low rates gave good companies the ability to get back on their feet before they went bankrupt. Its important to provide an economic environment that allows fundamentally sound firms to thrive. That may provide a temporary crutch to some companies that will eventually go bankrupt, but over the longer term, the right companies will survive. Nothing in life is perfect, and in terms of a trade-off, Im happy with a few bad companies staying in the game for a while if it means a lot of good ones have a chance to survive, too.

ROYCE: Thank you, Mr. Chairman.

Chairman Bernanke, I think the -- the risk -- risk weighting at the end of the day is -- is only as good as the metrics that we develop. I'm thinking back to Basel I. And now we're looking at the final Basel III. The Basel III includes a risk weighting of 20 percent for debt issued by Fannie Mae and Freddie Mac. And the rule includes a risk weighting of zero for -- unconditional debt issued by Ireland, by port -- by Portugal, by Spain, by other OECD countries with no country risk classification.

Both of these risk weightings are, in my memory, identical to the risk -- risk weightings under the original Basel I. So my -- my concern is that we should have learned a few things about those metrics given the -- consequences of -- of the clear failure. And yet, here we have the accord of 1988 looking an awful lot like this particular accord. Given what we have experienced, the failure of the GSEs, the propping up of many European economies, do you think these weightings accurately reflect the actual risk posed by these exposures?

BERNANKE: So Basel III and all Basel agreements are international -- you know, international agreements. And each country can take that floor and do whatever it wants, you know, above that floor. We would not allow a U.S. bank to hold Greek debt at zero weight, I assure you.

ROYCE: Yeah.

BERNANKE: In terms of GSEs, the GSE mortgage-backed securities have not created any loss whatsoever. They have to the taxpayer, but not to the holders of those securities. So that, I don't think, has been a problem. It's not just risk weights, though. But Basel III also has significantly increased the amount of high-quality capital that banks have to hold for a given set of risk -- risky assets.

“I have seen a disturbing uptick in what we call operational risk,” Raskin said on a panel today in Boston, referring to errors stemming from substandard bank management.

There are those who believe we have made great strides with Dodd-Frank and if we implement it well, all will be fine. Some believe that that the industry is over-regulated, which may be true, but we should not confuse over-regulated with well-regulated. And some of us are certain that in spite of all that’s been done and debated, the soundness of the largest financial institutions and the systemic risks they continue to pose is no better. In my view, it is even worse than before the crisis. As well-intentioned as the Dodd-Frank Act may be, it will not improve outcomes.

Instead, the main causes of the crisis originated in the financial sector and stemmed from a widespread underappreciation and underpricing of risk. Failures of risk-management systems, incentive problems in securitization and compensation structures, and regulatory shortcomings and gaps led to a vulnerable, overleveraged financial system with inadequate capital and liquidity buffers. These problems were amplified by the eagerness of U.S. households to take on huge amounts of mortgage debt and of lenders to advance them the credit, justified by overly optimistic expectations for house price appreciation as the real estate boom progressed.

But these financial sector problems were enabled, if not encouraged, by developments in the global economy. The capital outflows associated with the persistent current account surpluses were large even in net terms and, combined with relatively restrained business capital spending in many advanced economies (including the United States), put downward pressure on real interest rates globally.⁴ 

From a purely theoretical perspective, there is no compelling reason to believe that low real interest rates, by themselves, pose a particular risk to global economic and financial stability, as real interest rates should be driven by underlying forces to balance the global demand for saving and investment. Capital inflows from abroad can be beneficial if they are invested prudently. But in an environment in which the financial sector is prone to excess and the supervisory structure does not respond sufficiently, the interaction of low interest rates and financial vulnerabilities can clearly be dangerous. Notably, the generally stable macroeconomic environment that prevailed before the crisis may have exacerbated this problem, as it contributed to overly sanguine perceptions of risk.

Rather than financing productive business investment, capital inflows too often facilitated spending on housing and consumer goods. This circumstance was particularly true in the United States, where an innovative and entrepreneurial financial system aggressively competed for the opportunity to channel this capital to customers, in part by devising new and complex mortgage products. The resulting availability of funds and reduced interest rates boosted asset prices, particularly in the housing sector, and market participants assumed housing prices would continue to rise.

As the interest rate risk advisory issued by each of the financial regulators earlier this month recognized, interest rate risk is inherent in the business of banking. But it is especially important now for institutions to have in place sound practices to measure, monitor, and control this risk. They must not become distracted from this critical task by their efforts to deal with credit problems, nor can they think that assuming greater interest rate risk is a sound strategy for compensating for the losses they are taking on their loan portfolios. The recent crisis has been a stark reminder that borrowing short and lending long is an inherently risky business strategy.

A number of firms have learned hard, but valuable, lessons from the current crisis that they are applying to their internal processes to assess capital adequacy. These lessons include the linkages between liquidity risk and capital adequacy, the dangers of latent risk concentrations, the value of rigorous stress testing, the importance of strong governance over their processes, and the importance of strong fundamental risk identification and risk measurement to the assessment of capital adequacy. Perhaps one of the most important conclusions to be drawn is that all assessments of capital adequacy have elements of uncertainty because of their inherent assumptions, limitations, and shortcomings. Addressing this uncertainty is one among several reasons that firms should retain substantial capital cushions.

The leading proposals before Congress concentrate almost exclusively on expanding government protection and regulation, but I believe we would be better off placing greater reliance on market-based incentives for prudent risk management.

[L]iquidity risk management at the level of the firm, no matter how carefully done, can never fully protect against systemic events. In a sufficiently severe panic, funding problems will almost certainly arise and are likely to spread in unexpected ways. Only central banks are well positioned to offset the ensuing sharp decline in liquidity and credit provision by the private sector. They must be prepared to do so.

[M]y advice is to hope for the best and plan for the worst. That means anticipating a range of bad and worst-case scenarios that reflect local economic conditions and a bank’s particular risk profile.

The differences in the business models of systemically important financial firms and community banks are obvious.  Yet the financial crisis and ensuing recession have revealed deficiencies in risk management in institutions of both types.  Changes in competitive environments require banks to respond with changes in their business strategies.  But the financial crisis has also revealed the importance of banks adopting risk-management strategies appropriate to these strategic changes, and of bank regulatory agencies adapting their supervisory models to both these kinds of changes in financial institutions.

A critical component of risk management is understanding the links between incentives and risk-taking, such as in the design and implementation of compensation practices. Bonuses and other compensation should provide incentives for employees at all levels to behave in ways that promote the long-run health of the institution. The Federal Reserve has been working in international forums on compensation and incentives issues; one product of those efforts was the publication last month by the Financial Stability Board of new principles for sound compensation practices.⁷ Certainly, an important lesson of the crisis is that the structure of compensation and its effect on incentives for risk-taking is a safety-and-soundness issue.

[Y]ou might say that a systemic regulator must connect potential dots – not just actual dots. Assuming the systemic regulator has the ability to monitor solvency risk, liquidity risk, and risk management practices, and react to practices viewed as unsafe or unsound, some of the most serious financial problems might have been identified, and their severity lessened.

[B]efore we set clear and explicit objectives for financial stability, we first must be clear about what we mean by financial stability. Policymakers cannot and should not try to prevent all types of financial instability. Indeed, the economy benefits when financial institutions and markets take on and manage risk. That means inevitably some firms will fail. As my friend the economist Allan Meltzer has said, "Capitalism without failure is like religion without sin. It doesn't work."  Our goal should not be to try to prevent every failure, but rather to reduce the systemic risks to the financial system that a failure may create.