Today, although some of the most fragile investment vehicles and instruments that were involved in the pre-crisis shadow banking system have disappeared, non-deposit short-term funding remains significant. In some instances it involves prudentially regulated firms, directly or indirectly. In others it does not. The key condition of the so-called "shadow banking system" that makes it of systemic concern is its susceptibility to destabilizing funding runs, something that is more likely when the recipients of the short-term funding are highly leveraged, engage in substantial maturity transformation, or both…

First, the regulatory and public transparency of shadow banking markets, especially securities financing transactions, should be increased. Second, additional measures should be taken to reduce the risk of runs on money market mutual funds. The Council recently proposed a set of serious reform options to address the structural vulnerabilities in money market mutual funds.

Third, we should continue to push the private sector to reduce the risks in the settlement process for tri-party repurchase agreements. Although an industry-led task force made some progress on these issues, the Federal Reserve concluded that important problems were not likely to be successfully addressed in this process and has been using supervisory authority over the past year to press for further and faster action by the clearing banks and the dealer affiliates of bank holding companies.

Speaking before the Maryland Bankers Association, Fed Governor Raskin said "being a Governor in the post-financial-crisis era has made me much more sensitive to the importance of making sure we conduct examination and supervision in a way that helps ensure we think through potential consequences, such as unnecessarily hindering lending to creditworthy borrowers. Access to credit, after all, is a critical factor supporting recovery in our economy."

While the ability of businesses to access credit is a function of many factors, it is my view that the examination and supervision of the lender should not hinder the ability of creditworthy businesses to access credit. To be clear, I do not think this is occurring in any significant way, but it is an issue that we at the Federal Reserve focus on continually.

I would hope that, going forward, one thing we've learned from this crisis is there is a need for all of us in regulation to act in a timely way to take away the punch bowl and to require more stringent capital requirements.

The Federal Reserve also has responsibilities for banking supervision. In our capacity as a bank supervisor, we have joined the nation’s other bank regulatory agencies in issuing new guidance on small business and commercial real estate lending. What's really important about this new guidance, I think, is how it encourages bankers to work with their customers during periods of stress... We are trying to be prudent but reasonable in assessing bank managements’ handling of troubled loans. We do not want overzealous supervision to create additional problems for bankers and their customers.

But the bigger problem is one of incentives. Under the current system, if the Federal Reserve makes a bad loan through the TAF or through the discount window, that loss appears on its balance sheet. It has every incentive to do a good job in assessing the borrower quality.

Now suppose instead that some other agency were responsible for providing this information to the Federal Reserve. What exactly are this other agency’s incentives to provide the Federal Reserve with the best possible information? This other agency is not going to suffer a loss for making a bad loan—the Federal Reserve is. Indeed, one can readily imagine that in the politically charged circumstances of a financial panic, this other agency’s objective might be to keep as many banks alive as possible. In these circumstances, the Federal Reserve would have no way to obtain reliable information from this other regulatory body and would have no way to make appropriately targeted loans. As it is, the Federal Reserve has not lost any money on either TAF or discount window loans made during this period.

[W]e are prioritizing and expanding our program of horizontal examinations to assess key operations, risks, and risk-management activities of large institutions. For the largest and most complex firms, we are creating an enhanced quantitative surveillance program that will use supervisory information, firm-specific data analysis, and market-based indicators to identify developing strains and imbalances that may affect multiple institutions, as well as emerging risks to specific firms.

While effective consolidated supervision of potentially systemic firms is not, by itself, sufficient to foster financial stability, it certainly is a necessary condition. The Administration's recent proposal for strengthening the financial system would subject all systemically important financial institutions to the same framework for prudential supervision on the same consolidated or group-wide basis that currently applies to bank holding companies. In doing so, it would also prevent systemically important firms that have become bank holding companies during the crisis from reversing this change and escaping prudential supervision in calmer financial times.

Periods when earnings are strong and nonperforming loans are low are likely the times that a macroprudential supervisor would need to be particularly vigilant...[U]nlike the focus on incurred losses and accounting reserves of traditional safety and soundness supervision – a systemic regulator would need to be focused on forward-looking estimates of potential losses that could cause contagious failures of financial institutions.

I should acknowledge that even in traditional supervision, examiners can also focus on future or unexpected losses – and in theory, capital is expected to provide protection for losses occurring outside the accounting reserve model. But in practice, this is not always the case.

[A] systemic regulator should have the ability to supervise capital structure, supervise liquidity risk and asset-liability management, and supervise risk management – all to minimize the likelihood of systemically important institutions negatively impacting market functioning and economic stability, proving “contagious” to counterparties, and possibly needing government support to avoid further spreading damage or instability.

A systemic regulator or macroprudential supervisor would need not only the ability to monitor systemically important institutions, but also the ability to change behavior if firms are financing a boom by increasing leverage and liquidity risk. It follows that legislation that aims to design an effective systemic regulator needs to provide the regulator with the authority to make such changes.

If we have learned anything from the present crisis, it is that systemic risk was very much built into our financial system.  This situation was the outcome of a decades-long trend, during which traditional bank lending, trading, and other capital markets activities were increasingly integrated.

I hope we have learned that misaligned incentives that result in harm to consumers have implications for the economy overall. If we recognize this, then we must also recognize that consumer protections cannot be viewed as an ancillary component of a scheme to regulate for safety and soundness.

Let me...review in summary fashion what we regard as the key components of a legislative agenda to contain systemic risk.

First, there should be a statutory requirement for consolidated supervision of all systemically important financial firms--not just those affiliated with an insured bank as provided for under the Bank Holding Company Act of 1956 (BHC Act).

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Second, there should be a resolution regime for systemically important non-bank institutions to complement the current regime for banks under the Federal Deposit Insurance Act.

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Third, there should be clear authority for special regulatory standards--such as for capital, liquidity, and risk-management practices--applicable to systemically important firms.

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Fourth, there should be an explicit statutory requirement for analysis of the stability of the U.S. financial system.

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Fifth, additional statutory authority is needed to address the potential for systemic risk in payment and settlement systems.

Examination and understanding of the role of off-balance sheet activities deserves significantly more supervisory attention, going forward. It will be important to ensure that capital held for offbalance sheet exposures is commensurate with the risk that they pose.

Based on direct observation, I am not convinced that supervisors can consistently and effectively prevent excessive risk-taking by the large firms they oversee in a timely fashion, absent draconian measures that tend to throw out the good with the bad. For this reason, I am not confident that traditional S&R can reduce risk sufficiently such that it addresses the problems associated with TBTF status.⁶   While policymakers should improve S&R by incorporating the lessons learned over the last two years, it cannot be the bulwark in addressing TBTF.

I do see clear benefits in increasing the scope of bank-like resolution systems to entities such as bank holding companies....I have long argued that the resolution regime created by FDICIA would not, by itself, effectively limit after-the-fact protection for creditors of systemically important banks.