The Federal Reserve has been involved in a number of exercises to understand and document the risk-management lapses and shortcomings at major financial institutions, including those undertaken by the Senior Supervisors Group, the President's Working Group on Financial Markets, and the multinational Financial Stability Forum.¹

Based on the results of these and other efforts, the Federal Reserve is taking steps to improve regulatory requirements and risk management at regulated institutions.  Our actions have covered liquidity risk management, capital planning and capital adequacy, firm-wide risk identification, residential lending, counterparty credit exposures, and commercial real estate.  Liquidity and capital have been given special attention. 

An interesting historical example is the bank holiday of 1933 when Roosevelt shut down the banks for a week and said we're just going to check their books and open them up only when we think they're solvent -- and a lot of banks opened up pretty quick.  So it's not really clear how much they looked through the books but when they opened them up again, people felt much more comfortable, more confident in the banks.

Part of the proposal that Secretary Geithner put out this morning is to have a supervisory review not only of the quality of assets, the reserving, and the potential future losses, but also to ask the very important question: how well would the banks do in a very, even more severe scenario -- a stress test? Are they able to have enough capital that even putting aside whether they're solvent today that they could survive in an even worse scenario and to get confidence that they could survive that scenario -- put enough capital in so they could survive that scenario? That should help to restore confidence that they are, in fact, solvent and that would, in turn, attract private capital.

REP. MILLER: Assuming there was confidence in the stress test itself.

MR. BERNANKE: Correct.

From the Q&A session

Financial crisis can serve as a powerful stimulant to the evolution of market mechanisms, and I expect that the aftermath of the present turmoil will see both innovation and incremental refinement to quality assurance in credit markets and in counterparty credit risk management.  I would like to highlight two themes that I believe will influence this process.

First, for quality assurance to be effective, some of the products traded in financial markets have to become simpler and more transparent.

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A second key factor for effective quality assurance relates to the institutional and contractual framework for ensuring future performance on financial transactions, namely counterparty credit risk management.  Counterparty credit risk management should be focused on its effectiveness in different market situations and its implications for financial stability.

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(I)t is not just the banking industry, but also those of us in the public sector who have some key lessons to learn.  Banks and supervisors alike need to undertake additional work to facilitate the building of robust methods of quality assurance in the financial markets that will help to restore and maintain confidence.  Ensuring that banks exercise good risk management, of course, is an important job for bank supervisors, which includes overseeing their ability to properly capture the risks in the markets in which they operate, as well as their ability to conduct appropriate stress testing to explore potential consequences of different types of market distress.  Doing so requires that supervisors themselves develop a strong understanding of the value, limits, and potential harms associated with banks' attempts to protect their exposures.

(T)he ongoing fundamental transformation in financial services offers great potential opportunities for those institutions able to integrate strategy and risk management successfully, and I will argue that survival will hinge upon such an integration in what I will call a "strategic risk management framework."

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Over the past year there have been a number of studies analyzing the causes of the current turmoil, which include shortcomings in the risk management practices of financial institutions.² It is absolutely clear that many financial institutions need to undertake a fundamental review of risk management. They now realize that ignoring risk management in any aspect of the banking business usually creates problems later on. Risk management shortcomings need to be addressed not only to improve the health and viability of individual institutions, but also to maintain stability for the financial system as a whole.

Any change in regulation should be designed to ensure that no firm is “too big” or “too connected” to fail because of systemic concerns. Bailouts are expensive—not just because they commit taxpayer funds, but because they can encourage behavior that increases subsequent systemic risk.

We are ensuring that institutions take a more comprehensive and forward-looking approach to risk management across the entire firm, and are more intensely verifying assertions made by bank management about the robustness of their risk management capabilities.

Supervisors are also ensuring that banks understand the full spectrum and the scale of the risks inherent in increasingly complex banking activities and the potential for their risks to crystallize in times of stress. In particular, banks must focus on the inter-relationships among risk types, not just with respect to those areas that precipitated recent events, but more broadly.

Some institutions took an excessively narrow perspective on risk with insufficient appreciation of the need for a range of risk measures, including both quantitative and qualitative metrics.  For example, some firms placed too much emphasis on the mechanical application of value-at-risk or similar model-based indicators. Sophisticated quantitative tools and models play an important role in good risk management, and they will continue to do so. But no model, regardless of sophistication, can capture all of the risks that an institution might face. Those institutions faring better during the recent turmoil generally placed relatively more emphasis on validation, independent review, and other controls for models and similar quantitative techniques.... The leaders of well-managed institutions of all sizes generally seek to have strong and independent risk functions. 

[Companies need risk managers who] know when to take the punch bowl away from the party.

From audience Q&A as reported by Bloomberg News.

I will concentrate on four categories of risk-management practices:  risk identification and measurement, valuation practices, liquidity risk management, and senior management oversight.

For risks to be successfully managed, they must first be identified and measured. Recent events have revealed significant deficiencies in these areas. Notable examples are the underestimation by many firms of the credit risk of subprime mortgages and certain tranches of structured products. Other firms did not fully consider the linkages between credit risk and market risk, leading to mismeasurement of their overall exposure...

Valuation practices are a second area that supervisors' comparative reviews identified as critical. The SSG report indicates that those firms that paid close attention to the problems associated with the valuation of financial instruments, particularly those for which markets were not deep, fared better. These more-successful institutions developed in-house expertise to conduct independent valuations and refrained from relying solely on third-party assessments...

Weak liquidity risk controls were a common source of the problems many firms have faced.  For example, some firms' treasury functions were not given information from all business lines about either expected liquidity needs or contingency funding plans, in part because managers of individual business lines had little incentive to compile and provide this information...

Effective oversight of an organization as a whole is one of the most fundamental requirements of prudent risk management. The SSG report highlighted solid senior management oversight and engagement as a key factor that differentiated firms' performance during the recent events. Senior managers at successful firms are actively involved in risk management, which includes determining the firm's overall risk preferences and creating the incentives and controls to induce employees to abide by those preferences...

[D]espite a number of lessons from the recent financial turmoil, we should not despair, nor should we see investments in risk management as wasted. Indeed, had the discipline not advanced as far as it has, I believe the recent financial turmoil would be much more damaging.

Extreme losses have occurred much more frequently than we would have assumed four or five years ago ... When we were
first seeing billion dollar losses, people would say those are thousand year events ... but we need to think more about them now.

From Q&A as reported by Market News International

From the standpoint of private market discipline, this crisis has provided the first major test of securitization, complex financial instruments, risk modeling, and our new and broader market structure. Recent events indicate dismal test results: Many financial institutions and investors did not adequately judge, price or control the risks they assumed and did not prepare well for changing financial conditions.

If I were to select a light-hearted title for my remarks, it might be “Fear and Loathing on Wall Street.” The basic premise is that as firms have become increasingly concerned about the valuation (pricing) of certain assets, their ability to accurately assess counterparty risk and the liquidity position of counterparties has become clouded. The lack of transparency in the prices of underlying assets, and the significant losses of some financial firms whose deteriorating situation had not been evident in earlier financial statements, have together made investors skittish. As a result, financial firms are increasingly willing to pass up the use of other attractive financing opportunities if they believe that action might lead to speculation about the liquidity or financial strength of their firm.

While such skittishness is not unusual during periods of illiquidity, it is unusual for a period of illiquidity to last this long.

The volume of term lending transactions has declined significantly, with few buyers or sellers of term funds. I can suggest several reasons.

First, many potential suppliers of funds have become increasingly concerned about their capital position, causing them to look for opportunities to shrink (or slow the growth of) assets on their balance sheets, in order to maintain a desirable capital-to-assets ratio. Since unsecured inter-bank lending provides relatively low returns and has little benefit in terms of relationships, banks may prefer to use their balance sheet to fund higher-returning assets that advance long-term customer relationships.

Second, as the uncertainty over asset valuations has increased, banks have become reluctant to take on significant counterparty risk to financial institutions – particularly with those that have significant exposure to complex financial instruments.

Third, many potential borrowers are reluctant to buy term funds at much higher rates than can be obtained overnight, for fear that they may signal to competitors that they have liquidity concerns. However, when the counterparty is a central bank, financial institutions have been quite willing to buy term funding, sometimes at rates higher than they would expect if they were to borrow funds overnight.

I believe this period of illiquid markets should also cause central banks to re-evaluate their roles. For a central bank to play an effective role during financial turmoil, it needs to understand the sources of liquidity problems, the interrelationships between market participants, likely losses, and market participants’ potential reactions to these losses

In my view, this can only be done if the central bank has some form of hands-on supervisory experience with institutions – particularly the "systemically important" institutions – regardless of who is the primary regulator. The Federal Reserve has been far more effective during this crisis because it has hands-on experience with bank holding companies that are among the most significant players in many financial markets.

In short, there are significant synergies between bank supervision and monetary policy during periods of financial turmoil – synergies that can be used to achieve better outcomes for the public as policy makers try to determine the impact of liquidity problems and how changes in credit will impact the broader economy

Having some form of similarly hands-on supervisory experience with any systemically important financial institution that may need to access the Discount Window is, in the long term, critically important. We need to understand the solvency and liquidity positions of firms that may access the Discount Window – with access, at the very least, to the information any counterparty would require in a lending relationship. For those financial institutions that do have access to the Discount Window, there is indeed a need for the Fed to have broader access to information than marketplace counterparty creditors, if we are to effectively manage our responsibilities as lender of last resort and custodian of financial stability. So, regardless of who is the primary regulator, it is important for the Fed to understand the consolidated capital and liquidity positions of such firms.