As you know, the federal bank regulatory agencies began conducting the Supervisory Capital Assessment Program in late February. The program is a forward-looking exercise intended to help supervisors gauge the potential losses, revenues, and reserve needs for the 19 largest bank holding companies in a scenario in which the economy declines more steeply than is generally anticipated. The simultaneous comprehensive assessment of the financial conditions of the 19 companies over a relatively short period of time required an extraordinary coordinated effort among the agencies.

The purpose of the exercise is to ensure that banks will have a sufficient capital buffer to remain strongly capitalized and able to lend to creditworthy borrowers even if economic conditions are worse than expected. Following the announcement of the results, bank holding companies will be required to develop comprehensive capital plans for establishing the required buffers. They will then have six months to execute those plans, with the assurance that equity capital from the Treasury under the Capital Assistance Program will be available as needed.

[I]t seems plain that supervisory and regulatory policies could help prevent the kinds of problems we now face. Indeed, this was one of Minsky’s major prescriptions for mitigating financial instability. I am heartened that there is now widespread agreement among policymakers and in Congress on the need to overhaul our supervisory and regulatory system, and broad agreement on the basic elements of reform.

I expect the financial system to continue to involve a mix of capital markets and institutions, but with a wider array of institutions falling under regulatory supervision. Furthermore, I take it as given that there will continue to be large international institutions with operations in many countries, that is to say, regulatory jurisdictions around the globe.

Looking ahead, I see an ongoing role for securitization and the originate-to-distribute model. Securitization markets have shrunk dramatically over the last year and a half and in some cases have shut down altogether. I expect these markets to return, perhaps in simpler form and with more accountability.

[T]he track record of S/R does not suggest it prevents risk-taking that seems excessive ex post. True, long shots occasionally come in, and perhaps a regime dependent on conventional S/R would succeed, but it is NCAA tournament time, and we know that a 15 seed rarely beats a number two.

It seems likely that, going forward, there will be increased emphasis on tight regulation of financial institutions and their activities, especially of large, complex, “too-big or too-interconnected-to-fail” institutions. Clearly, there will be a role for conventional supervision and regulation in the future. Observers have rightly noted that the financial sector suffers from various market failures around issues of information and misaligned incentives, and conventional supervision and regulation can help address those concerns. At the same time, we have to be careful to avoid two potentially serious pitfalls: (1) excessive reliance on conventional supervision and regulation, essentially asking more than can be delivered; and (2) excessive regulation, resulting in an inefficient financial sector with negative consequences for economic performance.

[S]upervisors must pay close attention to compensation practices that can create mismatches between the rewards and risks borne by institutions or their managers. As the Federal Reserve and other banking agencies have noted, poorly designed compensation policies can create perverse incentives that can ultimately jeopardize the health of the banking organization. Management compensation policies should be aligned with the long-term prudential interests of the institution, be tied to the risks being borne by the organization, provide appropriate incentives for safe and sound behavior, and avoid short-term payments for transactions with long-term horizons.³

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.

This expansion of the scope and scale of Fed lending may not have been so large had we had better resolution mechanisms to deal with such failing firms as Bear Stearns and AIG. And perhaps our lending would not have become so wide-ranging had there been better regulation or more resiliency in the payment and settlement systems, including more transparency about the markets for mortgage-backed securities and credit default swaps.
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Some may think access to the Fed's lending facilities should be permanently expanded to include a wide range of financial institutions. I believe such expanded access to central bank credit would raise significant issues of moral hazard that would need to be addressed. And I have urged that we must continue to avoid compromising the Fed's independence — one of the great strengths of central banks.

Some people might think that expanding the Federal Reserve's regulatory and supervisory authority and giving it a sweeping mandate for financial stability would prevent the types of financial crises we have been experiencing this year. That is unrealistic.

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Going forward our focus should be on better regulation, not necessarily more regulation. We need to focus on ways to strengthen our financial markets to make market discipline more effective at mitigating systemic risk. We should think about which financial markets are critical to the efficient functioning of the payment system rather than focusing on individual firms. Ideally, we need to determine which aspects of the financial system are critical and then make sure we have the market mechanisms, regulations, and supervision to ensure those sectors are resilient.

We have long had a list of specific reforms to address TBTF, but we have not prioritized those proposals. So of the many recommendations we made, where would we have policymakers start? We would begin the effort to manage TBTF with an approach we call systemic focused supervision (SFS).

I earlier described SFS in general as an effort to apply a focus on spillover reduction to supervision, regulation, and communication as well, but let me now detail its three pillars: they are stress testing; enhanced prompt corrective action (PCA); and stability-related communication.

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.

Finally, it is worth noting that the Federal Reserve's umbrella supervision role closely complements our other central bank responsibilities, including the objectives of fostering financial stability and deterring or managing financial crises. The information, expertise, and powers derived from our supervisory authority enhances the Federal Reserve's ability to help prevent financial crises, and to manage such crises should they occur, working with the Treasury Department and other U.S. and foreign authorities. In this manner, enhancements to our consolidated supervision program, which include close coordination with primary supervisors and functional regulators, should provide broad benefits for the financial system and the economy.

I do not believe it would be desirable or feasible to extend capital requirements to institutions such as hedge funds or private equity firms. But supervision has to ensure that counterparty-credit risk management in the regulated institutions contains the level of overall exposure of the regulated to the unregulated. Prudent counterparty risk management, in turn, will work to limit the risk of a rise in overall leverage outside the regulated institutions that could threaten the stability of the financial system.

The Federal Reserve is nearing completion of enhancements to its supervisory guidance to clarify our role as consolidated supervisor of bank and financial holding companies--often known as our "umbrella supervisor" role... Again, from a financial stability perspective the Federal Reserve has an interest not just in identifying the risks within an individual organization, but also understanding the broader set of risks affecting all key market participants. 

(Chuckles.) Well, I think that if the taxpayer has taken an investment interest in a bank, the taxpayer has a right - as part owner - to protect itself. And I think bank regulators have a continuing obligation, if banks are having issues or are in need of government support, to get them to a point where they right their ship and in a position where they can eventually exit these government programs. So, to the extent that it means oversight of adequacy of management and boards, I think that’s absolutely appropriate for regulators to do.

And this is a new environment and we do need bank management and bank boards that know how to work through troubled environments, who know how to do good bread-and-butter basic bank risk management. And so those are the things we’re looking at, and I think that’s quite appropriate.

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I don’t like to get in the position of telling people to make appointments, but I think in terms of criteria, qualifications, I think those types of standards, we have an obligation to articulate.

In response to a question about whether banks on "government life support" should be able to be in charge of their own governance.

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.