So how do we strengthen market discipline? Today's priority is clearly market stability. However, looking beyond the immediate turmoil, we need to design carefully and put in place a stronger capacity for resolution and crisis intervention that reinforces market discipline....

To address the perception that some institutions are too big to fail, we must improve the tools at our disposal for facilitating the orderly failure of a large complex financial institution. As former Federal Reserve Chairman Greenspan often noted, the real issue is not that an institution is too big or too interconnected to fail, but that it is too big or interconnected to liquidate quickly.

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As I have continually noted, the financial landscape has changed, and non-bank financial institutions play a significantly greater role. We need to consider broadly the resolution regime in light of these changes. It is clear that some institutions, if they fail, can have a systemic impact, so we must give regulators the authorities to limit that impact and facilitate an orderly failure. In my view, looking beyond the immediate market challenges of today, we need to create a resolution process that ensures the financial system can withstand the failure of a large complex financial firm. To do this, we will need to give our regulators additional emergency authority to limit temporary disruptions. These authorities should be flexible and -- to reinforce market discipline -- the trigger for invoking such authority should be very high, such as a bankruptcy filing. And as part of this process we should consider ways to ensure that costs are imposed on creditors and equity holders. Any commitment of government support should be an extraordinary event that requires the engagement of the Executive Branch.

By mid-March, however, the pressures in short-term financing markets intensified, and market participants were speculating about the financial condition of Bear Stearns, a prominent investment bank. On March 13, Bear advised the Federal Reserve and other government agencies that its liquidity position had significantly deteriorated, and that it would be forced to file for bankruptcy the next day unless alternative sources of funds became available. A bankruptcy filing would have forced Bear's secured creditors and counterparties to liquidate the underlying collateral and, given the illiquidity of markets, those creditors and counterparties might well have sustained losses. If they responded to losses or the unexpected illiquidity of their holdings by pulling back from providing secured financing to other firms, a much broader liquidity crisis would have ensued. In such circumstances, the Federal Reserve Board judged that it was appropriate to use its emergency lending authorities under the Federal Reserve Act to avoid a disorderly closure of Bear. Accordingly, the Federal Reserve, in close consultation with the Treasury Department, agreed to provide short-term funding to Bear Stearns through JPMorgan Chase. Over the following weekend, JPMorgan Chase agreed to purchase Bear Stearns and assumed the company's financial obligations. The Federal Reserve, again in close consultation with the Treasury Department, agreed to supply term funding, secured by $30 billion in Bear Stearns assets, to facilitate the purchase.

It is a simple fact of history that, over a business cycle, markets tend toward excess optimism in which risk is seriously underestimated. In some cases, public policy is required to “bail out” undeserving parties so as to minimize the broader impact on the economy. It is also a fact that no matter the source of the financial problem, no matter the size of the institution or the region in which the problem emerges, the Federal Reserve will be part of any solution that is developed. This was the case in the ’70s, ’80s and ’90s during the foreign debt, farm, real estate and energy crises and is the case today. As a necessary principal party in prudential supervision and as the lender of last resort, the Federal Reserve is best positioned for this task.

One other important regulatory concern is that many of the steps public authorities have taken over the last year to stabilize the financial system seem likely to weaken market discipline and extend moral hazard problems to a much wider financial marketplace. A key example of this, the recent sale of Bear Stearns, seems to indicate that in a crisis situation, public authorities will not be in a position to let market discipline play out when larger financial institutions encounter problems. Bear Stearns’ collapse indicates that such phrases as “systemically important” and “too-big-to-fail” can even be applied to investment banks below the top tier.

The danger from a public policy perspective is that a much broader group of managers and creditors may now believe and act as if they have an added layer of protection from the risks they pursue. Beyond “too-big-to-fail” concerns, other market discipline and moral hazard problems may be inherent in some of the recent and more expansive proposals to support housing markets and in the actions the Federal Reserve had to take to provide liquidity to the market and expand discount window access.

There are no easy answers in dealing with this “too-big-to-fail” issue, but we need to take some strong steps if we are to restore the proper balance between financial risk and return and make market discipline effective. But we must be certain that whenever a bailout cannot be avoided, it should follow also that public authorities assume senior positions with respect to stockholders and other creditors at these “too-big-to-fail” institutions.

The line that separates restoring market function from merely redistributing losses and gains is not a bright one. This is the reason that policymakers only rarely and reluctantly intervene in markets.

Also, the distinction between liquidity problems and insolvency is not a trivial one when monetary authorities respond to troubles of market players. The critical evaluation is the systemic risk posed by the failure of an institution.

Some believe the Fed has overreacted. Others have said the central bank has been slow to respond to building problems. And still others have warned that the Fed has crossed lines that define appropriate function.

But from where I stand, Fed actions were taken with a prudent acknowledgement of the unintended consequences that may accompany almost all policy interventions.

While governments cannot and should not uniformly avoid public support for creditors of failing banks, they should seek to minimize that support because of the distortions it produces. Such public support—even when it passes a benefit-cost test at the time of provision—encourages future risk-taking by institutions whose creditors expect to benefit from future support. Such risk-taking can even contribute to the specific financial conditions that prompt further government support. The key to addressing these costs is, when times are good, to act to reduce creditors’ expectations of receiving protection.

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Policymakers should also undertake steps to better understand the potential for spillovers before large institutions get in trouble, as this would allow them to target any support they provide, or perhaps make it more likely that support could be avoided. Because I believe spillovers drive the provision of after-the-fact government support, I am not convinced that other approaches are as likely to alter creditors’ expectations.

Recent events have likely reaffirmed and strengthened some creditors’ expectations of support, or have created those expectations for the first time. I think one would be hard pressed to dismiss our analyses or proposals by claiming that such expectations do not exist. On the opposite end of the spectrum, some might dismiss our suggestions, arguing that we cannot influence creditors’ expectations. I reject that view as equally untenable. We simply cannot allow widespread perceptions of government support to pervade the financial system. Experience in other countries suggests that such a strategy is quite costly. And, in any case, our proposals seek to reduce systemic risk, an outcome presumably shared by policymakers regardless of their views on TBTF per se.

 In that situation, any intervention ought to take a form such that the costs to shareholders and management are so large that no firm in the future will want to allow itself to fall into such a situation. Lest I be regarded as a soft touch when I say that a situation could arise that could make intervention “inevitable,” I would set a very high bar to any intervention. Here is what I think is sound advice: “Experience suggests that the path of wisdom is to use monetary policy explicitly to offset other disturbances only when they offer a ‘clear and present danger.’” Some may be surprised to learn that the author of this sentence was Milton Friedman in his presidential address to the American Economic Association in 1967.

As I have emphasized before, the Federal Reserve can deal with liquidity pressures but cannot deal with solvency issues. I do not have any information on the GSEs that the market does not also have. Nevertheless, in assessing the risk of further credit disruptions this year, I would put the GSEs at the top of my list of sources of potentially serious problems. If those problems were realized, they would be a direct result of moral hazard inherent in the current structure of the GSEs.

Asked about whether it is true some financial institutions are too big to fail he said former Fed Chairman Alan Greenspan had it right when he said no institution is too big to fail, but the big ones can't be liquidated very quickly. In any event, it's the big bank shareholders
who would be wiped out and probably management too, not the customers of the bank which would be fixed so it could survive.

As reported by Market News International

We need to accept that accidents will happen--that asset prices will fluctuate, often over wide ranges, and those fluctuations will be driven in part by trading strategies, by the cycles of greed and fear that have always been with us, and by the ebb and flow of competition for market share. The fluctuations will result in redistributions of wealth and, on occasion, will confront us with financial crises. But we cannot and should not try to prevent this process through a monetary policy that puts special emphasis on stabilizing asset prices or through regulatory policies that limit access to markets by qualified participants or that attempt to restrain competition materially. Monetary policy that proactively leans against asset price movements runs a considerable risk of yielding macroeconomic results that fall short of maximum sustainable growth and price stability. Regulatory policies that try to prevent failures of core participants or others under all conceivable circumstances will tend to stifle innovation and reduce our economy's potential for long-run growth.

Both market participants and public authorities should understand that, despite our best efforts, crises are inevitable, and so we need to work on crisis management as well. Here, too, cooperation among authorities here and abroad is critical. We must understand the market structures and vulnerabilities and the objectives and constraints under which authorities with different jurisdictions would be working in those circumstances.

Inevitably, uncertainty on the part of market participants and public authorities will be heightened in the event of market turmoil, and that uncertainty can feed on itself. Both authorities and participants need to think through how they will handle such crises. For the authorities, that process includes considering how to resolve any failures of large institutions in ways that impose costs on shareholders and uninsured liability holders while preserving orderly markets. Such a resolution will be necessary to limit the moral hazard of any interventions that we are forced to undertake. Market participants need to consider how they would settle contracts and work with troubled borrowers in a distress situation. More planning will reduce the rise in uncertainty in a crisis and the likelihood that fear will lead to precipitous actions that are in no one's best interest.

Credible receivership provisions for insolvent banks are another method of enhancing market discipline. Effective market discipline requires that uninsured investors believe they could lose some, or all, of their stake. This belief is especially important in the case of very large banks, which investors may otherwise perceive to be too big to fail. Receivership rules that make clear that investors will take losses when a bank becomes insolvent should increase the perceived risk of loss and thus also increase market discipline.

In the United States, the banking authorities have ensured that, in virtually all cases, shareholders bear losses when a bank fails. Historically, however, bondholders and uninsured depositors have at times doubted that regulators would impose significant losses on them in the event of a bank’s failure. To address this issue, the Congress has reduced regulators’ discretion when dealing with troubled banks. For example, the requirement for prompt corrective action prohibits regulatory forbearance when a bank’s capital falls to a predetermined level; and the least-cost-resolution requirement compels regulators to resolve a troubled bank at the lowest cost to the deposit insurance fund.²

FDICIA allowed for the relaxation of its least-cost mandate in situations posing a true systemic crisis. But the conditions under which least-cost resolution can be relaxed are quite strict. First, a least-cost resolution would have to create "serious adverse effects on economic conditions or financial stability." Second, any action under the exception must be recommended by at least two-thirds majorities of the boards of both the FDIC and the Federal Reserve and ultimately approved by the Secretary of the Treasury in consultation with the President.

The systemic-risk exception has never been invoked, and efforts are currently underway to lower the chances that it ever will be.