Where do we stand with respect to fixing the problem of "too big to fail" (TBTF)? Are we making satisfactory progress, or it is time to think about further measures?

...While I agree that we have a long way to go, I believe that the way to get there is not by abandoning the current reform agenda, but rather by sticking to its broad contours and ratcheting up its forcefulness on a number of dimensions. In this spirit, two ideas merit consideration: (1) an increase in the slope of the capital-surcharge schedule that is applied to large complex firms, and (2) the imposition at the holding company level of a substantial senior debt requirement to facilitate resolution under Title II of Dodd-Frank. In parallel with the approach to capital surcharges, a senior debt requirement could also potentially be made a function of an institution's systemic footprint.

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Suppose instead we attack the problem by imposing capital requirements that are an increasing function of bank size. This price-based approach creates some incentive for all three banks to shrink, but lets them balance this incentive against the scale benefits that they realize by staying big. In this case, we would expect A, with its significant scale economies, to absorb the tax hit and choose to remain large, while B and C, with more modest scale economies, would be expected to shrink more radically. In other words, price-based regulation is more flexible, in that it leaves the size decision to bank managers, who can then base their decision on their own understanding of the synergies--or lack thereof--in their respective businesses.

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Suppose we do everything right with respect to capital regulation, and set up a system of capital surcharges that imposes a strong incentive to shrink on those institutions that don't create large synergies. How would the adjustment process actually play out? The first step would be for shareholders, seeing an inadequate return on capital, to sell their shares, driving the bank's stock price down. And the second step would be for management, seeking to restore shareholder value, to respond by selectively shedding assets.

But as decades of research in corporate finance have taught us, we shouldn't take the second step for granted. Numerous studies across a wide range of industries have documented how difficult it is for managers to voluntarily downsize their firms, even when the stock market is sending a clear signal that downsizing would be in the interests of outside shareholders. Often, change of this sort requires the application of some external force, be it from the market for corporate control, an activist investor, or a strong and independent board.11 As we move forward, we should keep these governance mechanisms in mind, and do what we can to ensure that they support the broader regulatory strategy.

The Federal Reserve takes seriously its responsibility to ensure that supervisory actions to protect banks' safety and soundness do not unintentionally constrain lending to creditworthy borrowers, and we have taken a variety of steps to address these concerns. For example, we have issued guidance to supervisors stressing the importance of taking a balanced approach to supervision and of promptly upgrading a bank's supervisory rating when warranted by a sustainable improvement in its condition and risk management. Some analysis has indicated that, all else being equal, banks with lower supervisory ratings tend to lend less; prompt upgrades by supervisors when such upgrades are appropriate may thus ease an unnecessary constraint on lending. Indeed, in the fourth quarter of 2011 and the first quarter of this year, the number of ratings upgrades for banks and bank holding companies supervised by the Federal Reserve exceeded the number of downgrades.

No one can argue with the need for stronger regulation to prevent the lending abuses that led to the current foreclosure crisis. However, I think it would also be unfortunate if the laws and regulations put in place to require other lenders to adopt the same responsible practices long used by community banks are so complicated and expensive that they have the unintended effect of forcing some community banks to leave the market.

The Federal Reserve continues to encourage bank examiners to adopt a balanced approach to reviewing banks' lending to small businesses. We would like to foster an environment in which lenders do all they can to meet the needs of creditworthy borrowers while maintaining appropriately prudent underwriting standards.

Small businesses, which depend importantly on bank credit, have been particularly hard hit by restrictive lending standards. At the Federal Reserve, we have been working to facilitate the flow of funds to creditworthy small businesses. Along with the other banking supervisors, we have emphasized to banks and examiners that lenders should do all they can to meet the needs of creditworthy borrowers, including small businesses. We also have conducted extensive training of our bank examiners, with the message that lending to viable small businesses is good for the safety and soundness of our banking system as well as for our economy.

I do not believe it is appropriate or even possible for regulators to urge banks to make loans that are outside their risk tolerance or that would be unsafe or unsound. But we can and should be sure that supervisory policies do not impede the flow of credit to all eligible borrowers. That's why the Federal Reserve and other regulatory agencies have worked so hard during the past few years to ensure that while banks appropriately recognize loan problems they also can continue to make loans that are safe and sound.

Our message is clear: Consistent with maintaining appropriately prudent standards, lenders should do all they can to meet the needs of creditworthy borrowers.  Doing so is good for the borrower, good for the lender, and good for our economy.

The Federal Reserve has been working to ensure that our bank supervision does not inadvertently impede sound lending and thus slow the recovery. Achieving the appropriate balance between necessary prudence and the need to continue making sound loans to creditworthy borrowers is in the interest of banks, borrowers, and the economy as a whole. Toward this end, in cooperation with the other banking regulators, we have issued policy statements to bankers and examiners emphasizing the importance of lending to creditworthy customers, working with troubled borrowers to restructure loans, managing commercial real estate exposures appropriately, and taking a careful but balanced approach to small business lending.² We have accompanied our guidance with training programs for both Federal Reserve and state examiners, and with outreach to bankers throughout the industry. For example, we just completed a training initiative that reached about 1,000 examiners. We are also conducting a series of meetings across the country with private- and public-sector partners to gather information about the credit needs of small businesses and how those needs can best be met.

Once, again, we've issued guidance to the banks about encouraging lending to small businesses and have trained our own examiners to take a balanced perspective, that they not over-penalize loans to small businesses. And we are trying to get as much feedback as we can. For example, we have inserted questions in the NFIB survey to get back more information from small businesses about their credit experience. And currently our Reserve banks around the country are holding meetings with small businesses, banks and community development groups to try to understand better what the issues are and how we can improve small business lending.

In response to a question about the Fed's efforts to stimulate small business lending

[W]e recognize that the ongoing financial and economic stress has resulted in a decrease in credit availability, including loans to small businesses, and has prompted institutions to review their lending practices. Although current loss rates would indicate that a measure of tightening was appropriate and necessary, some institutions may have become overly cautious in their lending practices. Thus, while prudence must remain the watchword for both banks and their supervisors, we do not want our examiners to take an overly mechanistic approach to evaluating small business lending.

I expect securitization to continue because this form of financial intermediation developed in response to needs and realities that have not disappeared. I was a commercial banker in the 1980s and I remember well the onset of the practice of balance sheet allocation according to return on assets and ultimately return on equity. Commercial banks were, and remain, caught in a dilemma of wanting to serve their clients by providing loans, but not always being able to justify booking very competitively priced loans on their balance sheets.

Banks with the lowest supervisory ratings have reduced their lending significantly more than have banks in better health.  Empirical research suggests that during previous banking crises this behavior was, to an important degree, explained by differences in the ability to supply credit not just differences in the demand for credit. [Footnote 5] Thus the evidence from Japan and previous problems in the U.S. indicates that allowing poorly capitalized banks to continue operations with insufficient capital is likely to exacerbate problems with credit availability.

Cooperation between the Fed and the SEC is taking place within the existing statutory framework with the objective of addressing the near-term situation. In the longer term, however, legislation may be needed to provide a more robust framework for the prudential supervision of investment banks and other large securities dealers. In particular, under current arrangements, the SEC's oversight of the holding companies of the major investment banks is based on a voluntary agreement between the SEC and those firms. Strong holding company oversight is essential, and thus, in my view, the Congress should consider requiring consolidated supervision of those firms and providing the regulator the authority to set standards for capital, liquidity holdings, and risk management.⁶ At the same time, reforms in the oversight of these firms must recognize the distinctive features of investment banking and take care neither to unduly inhibit innovation nor to induce a migration of risk-taking activities to less-regulated or offshore institutions.

I believe the severity and complexity of this crisis makes a compelling case for a comprehensive reassessment of how to use regulation to strike an appropriate balance between efficiency and stability. This is exceptionally complicated, both in terms of the trade-offs involved and in building the necessary consensus in the United States and the world. It is going to require significant changes to the way we regulate and supervise financial institutions, changes that go well beyond adjustments to some of the specific capital charges in the existing capital requirement regime for banks.

Our goal is to emerge from this difficult period with a financial system that will be more stable without being less innovative, with a more effective balance between market discipline and regulation.