[L]et me close by addressing a question that often arises about the use of a supervisory stress test, such as those conducted by the Fed, with common scenarios and models. Such a test may create the possibility of, in former Chairman Bernanke's words, a "model monoculture," in which all models are similar and all miss the same key risks. Such a culture could possibly create vulnerabilities in the financial system. At the Fed we try to address this issue, in part, through appropriate disclosure about the supervisory stress test. We have published information about the overall framework employed in various aspects of the supervisory stress test, but not the full details that banks could use to manage to the test. This--making it easier to game the test--is the potential negative consequence of transparency that I alluded to earlier.

The Dodd-Frank Act mandates supervisory stress tests that assess whether large bank holding companies have a sufficient level of capital to absorb losses during adverse economic conditions.4 The Federal Reserve also conducts a capital planning exercise, called the Comprehensive Capital Analysis and Review or CCAR. This evaluation combines the quantitative results from the Dodd-Frank Act stress tests with a qualitative assessment of whether the largest bank holding companies have vigorous, forward-looking capital planning processes that account for their unique risks. The criteria for both sets of stress tests are dynamic and change in response to evolving risks. For example, past tests have assumed a sharp, sudden, and widespread drop in markets triggered by, say, a large Eurozone shock. The tests also evaluate market interconnectedness, including the risk of major counterparty default.

As part of this effort, I have proposed four specific reforms to curb incentives for illegal and unduly risky conduct at banks. First, banks should extend the deferral period for compensation to match the timeframe for legal liabilities to materializeperhaps as long as a decade. Second, banks should create de facto performance bonds wherein deferred compensation for senior managers and material risk takers could be used to satisfy fines against the firm for banker misbehavior. Third, I have urged Congress to enact new federal legislation creating a database that tracks employees dismissed for illegal or unethical behavior. Fourth, I have requested that Congress amend the Federal Deposit Insurance Act to impose a mandatory ban from the financial systemthat is, both the regulated and shadow banking sectorsfor any person convicted of a crime of dishonesty while employed at a financial institution.

For starters, the Federal Reserve now makes its most consequential supervisory decisions on a system-wide level through the Large Institution Supervision Coordinating Committee or LISCC. The committee comprises representatives across professional disciplines from several Reserve Banks and the Board of Governors. The New York Fed supplies only three of its 16 members. LISCC sets supervisory policy for the 15 largest, most systemically important financial institutions in our country and develops innovative, objective, and quantitative methods for assessing these firms on a comparative basis.

In recent years, there have been ongoing occurrences of serious professional misbehavior, ethical lapses and compliance failures at financial institutions. This has resulted in a long list of large fines and penalties, and, to a lesser degree than I would have desired employee dismissals and punishment.

I reject the narrative that the current state of affairs is simply the result of the actions of isolated rogue traders or a few bad actors within these firms. As James OToole and Warren Bennis observed in their Harvard Business Review article about corporate culture: Ethical problems in organizations originate not with a few bad apples but with the barrel makers. That is, the problems originate from the culture of the firms, and this culture is largely shaped by the firms leadership. This means that the solution needs to originate from within the firms, from their leaders.

For the economy to achieve its long-term growth potential, we need a sound and vibrant financial sector. Financial firms exist, in part, to benefit the public, not simply their shareholders, employees and corporate clients. Unless the financial industry can rebuild the public trust, it cannot effectively perform its essential functions. For this reason alone, the industry must do much better.

In conclusion, if those of you here today as stewards of these large financial institutions do not do your part in pushing forcefully for change across the industry, then bad behavior will undoubtedly persist. If that were to occur, the inevitable conclusion will be reached that your firms are too big and complex to manage effectively. In that case, financial stability concerns would dictate that your firms need to be dramatically downsized and simplified so they can be managed effectively.

I want to observe that regulators can unwittingly reinforce what I have termed a mere compliance mentality. I would first note that the detail of many regulations means that attention to narrow issues of compliance is sometimes wholly understandable and, indeed, essential. Banks, like other regulated entities, need to be able to determine how a regulation actually applies to them. Beyond that kind of unavoidable focus on narrow compliance, however, management and line employees are more likely to adopt a mere compliance mentality where regulations appear to them to have been poorly drafted or implemented This is an outcome that regulators can avoid, and something with which the regulated firms themselves can assist by pointing out what they would regard as more sensible methods for achieving stated regulatory purposes.

Innovative new opportunities for risk-taking will always emerge as financial markets and economies evolve, and it is asking too much to expect front-line supervisors to forever substitute for well-aligned incentives. Moreover, stronger restraints on risk-taking increase the incentive for market participants to find a way to operate beyond the scope of regulation. Expanding regulation to chase down fragility wherever it appears is not a promising strategy.

There are some who believe that macroprudential supervision will safeguard us from financial instability. I am more skeptical. Such supervision entails the vigilant monitoring of capital and liquidity ratios, tighter restrictions on bank practices and subjecting banks to stress tests. Although these macroprudential disciplines are important steps in reducing systemic risk, I also think it is important to remember that this is not your grandparents financial system. The Federal Reserve and the banking supervisory authorities used to oversee the majority of the credit system by regulating depository institutions; now, depository institutions account for no more than 20 percent of the credit markets. So, yes, we have appropriately tightened the screws on the depository institutions. But there is a legitimate question as to whether these safeguards represent no more than a financial Maginot Line, providing us with an artificial sense of confidence. [T]he term Maginot Line is commonly used to connote a strategy that clever people hoped would prove effective, but instead fails to do the job.

Born of necessity during the depths of the financial crisis as part of an effort to restore confidence in the U.S. financial system, supervisory stress testing has in the intervening five years become a cornerstone of a new approach to regulation and supervision of the nation's largest financial institutions. First, of course, it is a means for assuring that large, complex financial institutions have sufficient capital to allow them to remain viable intermediaries even under highly stressful conditions. More broadly, supervisory stress testing and the associated review of capital planning processes have provided a platform for building out a regulatory framework that is more dynamic, more macroprudential, and more data-driven than pre-crisis practice...

While some important features of capital planning are observable only during the formal CCAR process, most of the risk-management and capital planning standards incorporated in CCAR are operative and observable by supervisors throughout the year. These should be an important focus of ongoing supervisory oversight and of discussions between firms and supervisors. Only in unusual circumstances should supervisors learn for the first time during CCAR of significant problems in the quality of the capital planning processes, and only in unusual circumstances should firms be surprised at the outcome of the qualitative assessment.

We have already taken steps to further this integration of CCAR and regular supervision. At the end of each CCAR process our supervisors send to each firm a letter detailing their conclusions concerning the qualitative assessment. To the extent weaknesses or areas for improvement are identified, those letters provide a basis for regular stocktaking by both firms and supervisors. More generally, last year we released a paper on our expectations for all aspects of capital planning, providing greater detail than what is included in the annual CCAR instructions.

I anticipate that we will take additional steps to integrate ongoing supervisory assessments of risk-management and other internal control processes with the annual CCAR exercise, and to assure that communications in both directions are heard. One such step has just recently begun: The committee chaired by senior Board staff that is responsible for the oversight of CCAR, supported by the relevant horizontal assessment teams, will directly engage with firms during the course of the year to evaluate progress in remediating weaknesses or other issues identified in the post-CCAR letters. Increasingly, our regular supervisory work on topics such as risk-identification and internal audit will focus on processes that are critical to risk management and capital planning at the firms, areas of focus for CCAR. The aim of these and additional measures is to make CCAR more the culmination of year-round supervision of risk-management and capital planning processes than a discrete exercise that takes place at the same time as the supervisory stress tests...

Although strong capital regulation is critical to ensuring the safety and soundness of our largest financial institutions, it is not a panacea, as indeed no single regulatory device can ever be. Similarly, supervisory stress testing and CCAR, while central to ensuring strong capital positions for large firms, are not the only important elements of our supervisory program. Having said that, however, I hope you will take at least these three points away from my remarks today.

First, supervisory stress testing has fundamentally changed the way we think about capital adequacy. The need to specify scenarios, loss estimates, and revenue assumptions--and to apply these specifications on a dynamic basis--has immeasurably advanced the regulation of capital adequacy and, thus, the safety and soundness of our financial system. The opportunities it provides to incorporate macroprudential elements make it, in my judgment, the single most important advance in prudential regulation since the crisis.

Second, supervisory stress testing and CCAR have provided the first significant form of supervision conducted in a horizontal, coordinated fashion, affording a single view of an entire portfolio of institutions, as well as more data-rich insight into each institution individually. As such, these programs have opened the way for similar supervisory activities and continue to teach us how to organize our supervisory efforts in order most effectively to safeguard firm soundness and financial stability.

Finally, supervisory stress testing and CCAR are the exemplary cases of how supervision that aspires to keep up with the dynamism of financial firms and financial markets must itself be composed of adaptive tools. If regulators are to make the necessary adaptations, they must be open to the comments, critiques, and suggestions of those outside the regulatory community. For this reason, transparency around the aims, assumptions, and methodologies of stress testing and our review of capital plans must be preserved and extended.

There are many important regulatory requirements applicable to large financial firms. Boards must of course be aware of those requirements and must help ensure that good corporate compliance systems are in place. But it has perhaps become a little too reflexive a reaction on the part of regulators to jump from the observation that a regulation is important to the conclusion that the board must certify compliance through its own processes. We should probably be somewhat more selective in creating the regulatory checklist for board compliance and regular consideration. One example, drawn from Federal Reserve practice, is the recent supervisory guidance requiring that every notice of a "Matter Requiring Attention" (MRA) issued by supervisors must be reviewed, and compliance signed off, by the board of directors. There are some MRAs that clearly should come to the board's attention, but the failure to discriminate among them is almost surely distracting from strategic and risk-related analyses and oversight by boards.

I am skeptical of a clean separation principle that places financial stability squarely in the purview of the supervisors. Instead, I think monetary policymakers also need to maintain a careful eye on the financial system and how interest rate policy affects incentives for financial markets and institutions.

We are also now using periodic newsletters and other communication tools to highlight information that community bankers may be interested in knowing and to provide information on how examiners will assess compliance with Federal Reserve policies…The common goal for all of these outreach efforts is building and sustaining an ongoing dialogue with community bankers.

One theme that has come through loud and clear in this outreach is concern about regulatory burden. The financial crisis has prompted significant changes to regulation, so the Federal Reserve understands this concern and strives to minimize regulatory burden for all institutions, including community banks. At the same time, we are taking a fresh look at how we supervise community banks and possible ways that supervision can be smarter, more nimble, and more effective. In that regard, and consistent with my earlier points about too big to fail, we know that a one-size-fits-all approach to supervision is often not appropriate. In recent years, we have taken a number of actions to tailor supervisory expectations to the size and complexity of the banking organizations we supervise.

It is too easily assumed that financial models, stress tests and macroprudential supervision will provide smarter supervision and identify what is presumed to have been missed by examiners in the run-up to the 2008 financial crisis. However, a more thorough analysis suggests that the largest banks were more vulnerable because regulators relied too heavily on erroneous assumptions about the quality of governance and controls over incentives, sophistication and measurement of risk management, and the strength of market discipline. As a result, regulators had already given up on the type of full-scope examinations that smaller institutions typically experience. Prior to 2008, most of the supervisory emphasis centered on a large institutions models and risk weights, and far less effort was given to a thorough examination and critical analysis of its loan portfolio, funding strategies and exposure to exotic risks such as synthetic derivatives. The Dodd-Frank Act requires enhanced prudential standards for firms in the United States that pose elevated risk to financial stability. These macroprudential efforts are worthy exercises, but no matter the tool, experience and informed judgments provided by trained and experienced staff are required to meet todays heightened supervisory expectations. Data and models provide information and choices that must be evaluated in the context of the more subjective or qualitative elements of the organization, such as the quality of internal controls and protocols, management and organizational culture.

The board operates under a variety of restrictions. You may know about the Government in the Sunshine rule. And so when you suggest that the board meet to discuss regulatory -- regulatory matters, our ability to do so outside of open meetings is very limited. And so we tend to handle those by meeting individually with staff or meeting in small groups. We have a committee system where committees are put in charge of managing particular areas and making recommendations to the board.

I remember in the 1990s that the board did regularly meet to discuss supervisory issues because, you know, there there's confidential supervisory information and it's easier for us to have a meeting, and I did consider those very valuable. And so I think that's a very worthwhile idea.

When there -- I should just say, when there are delegations to staff and the Board of Governors doesn't vote, that doesn't mean that board members aren't consulted, and maybe those with expertise may have played a critical role and had very important input even when there is no formal vote by the Board Governors.

In response to a question about why enforcement decisions are delegated to the staff

Many of the key problems related to shadow banking and their potential solutions are still being debated domestically and internationally, but some of the necessary steps are already clear.

First, we need to increase the transparency of shadow banking markets so that authorities can monitor for signs of excessive leverage and unstable maturity transformation outside regulated banks. Since the financial crisis, the ability of the Federal Reserve and other regulators to track the types of transactions that are core to shadow banking activities has improved markedly. But there remain several areas, notably involving transactions organized around an exchange of cash and securities, where gaps still exist. For example, many repurchase agreements and securities lending transactions can still only be monitored indirectly. Improved reporting in these areas would better enable regulators to detect emerging risks in the financial system.

Second, we need to reduce further the risk of runs on money market mutual funds. Late last year, the Council issued a proposed recommendation on this subject that offered three reform options. Last month, the SEC issued a proposal that includes a form of the floating net asset value (NAV) option recommended by the Council.

Third, we need to be sure that initiatives to enhance the resilience of the triparty repo market are successfully completed. These marketwide efforts have been underway for some time and have already reduced discretionary intraday credit extended by the clearing banks by approximately 25 percent. Market participants, with the active encouragement of the Federal Reserve and other supervisors, are on track to achieve the practical elimination of all such intraday credit in the triparty settlement process by the end of 2014.

Completing these three reforms would represent a strong start to the job of reducing systemic risk in the short-term wholesale funding markets that are key to the functioning of securities markets.