The Administration's proposal addresses the need for broader-based identification of systemic risks across the economy and improved interagency cooperation through the establishment of a new Financial Services Oversight Council. The Oversight Council described in the Administration's proposal currently lacks sufficient authority to effectively address systemic risks.

In designing the role of the Council, it will be important to preserve the longstanding principle that bank regulation and supervision are best conducted by independent agencies. Careful attention should be given to the establishment of appropriate safeguards to preserve the independence of financial regulation from political influence.

See further comments on an oversight council:
Mary Schapiro's Testimony ; Daniel Turullo's Testimony

[T]he Federal Reserve Board believes there is a compelling case for leaving consumer protection rule writing functions within the Federal Reserve and supervision with the agencies responsible for prudential supervision. While arguments for consolidating functions can themselves be compelling, it is important to also consider the substantial opportunities presented by existing arrangements.
...
[T]he Federal Reserve has the resources, the structure, and the experience to execute an ongoing comprehensive program for effective consumer protection in financial services...[W]e believe that replicating in another agency the deep expertise and full array of functions embedded within the Federal Reserve and used to support our consumer protection program would be enormously challenging. We also view consumer protection as complementary to, rather than in conflict with, other responsibilities at the Federal Reserve, such as prudential supervision and fostering financial stability.

My personal view is that the Federal Reserve is well placed to do a good job in the public interest on consumer regulation. I think the fact that we have various disciplines within the (Fed) system: we have a view of the macroeconomy, the markets, our supervision system -- these are congruent with good consumer regulation. (They) give us a way of balancing issues having to do with consumer regulation…I would hope that the Congress might think about whether there are ways of strengthening the Federal Reserve's commitment to consumer regulation as an alternative to creating a new regulator.

As reported by Reuters.

I do believe that we can do a much better job of preventing (albeit, not entirely avoiding) crisis situations and I believe we can be better prepared to address them when they do occur. Much of the current policy discussion on the need for some form of a systemic risk regulator and improved resolution process is most appropriate and should be thoroughly vetted. Both ideas are included in President Obama's regulatory reform proposal that was recently sent to Congress. Obviously, there are a number of details to be addressed, but I hope we can grasp the moment and not let the opportunity to implement meaningful reform pass.

Some have well illustrated the responses associated with the recent crises to an emergency crew acting to save a burning home before it destroys the entire neighborhood. I agree that acting to save the neighborhood was important. However, to extend the metaphor, if the fire was started by a homeowner who ignored fire codes and smoked in bed, should the neighbors be required to rebuild the home at twice its original size at their expense?

www.wrightson.com/federal_reserve/fedspeak/item/4587

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.

Periods of market booms and other expansionary periods are precisely the times that macroprudential supervision would diverge from more traditional prudential supervision. Historically, prudential supervision has been largely reactive, becoming more activist as losses mount (or conditions otherwise deteriorate) at an institution. In contrast, a macroprudential supervisor should be particularly attuned to changes – especially dramatic ones – in such areas as leverage, asset-liability mix, or underwriting standards. This requires the macroprudential supervisor to be willing and able to “lean against the wind” during booming markets or other periods.

[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.

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.

Solving the boundary problem alone will not counterbalance contemporary sources of systemic risk. The rapid development of market-based financial intermediation has also highlighted the need for a macroprudential regulatory approach to complement more conventional prudential supervision.

[C]ompensation systems that incentivize employees to take actions that entail excessive risk in light of expected returns and costs can also have adverse effects on firm safety and soundness. While there is reason to proceed carefully in this area, there is a real need for additional supervisory action to strengthen previous guidance on compensation. The Board is currently developing proposals that will help ensure that compensation systems take appropriate account of the riskiness of the firm's activities as well as the firm's financial performance.

In my view, the postcrisis environment will require agile oversight. This regulatory approach should stress actively managing risk as it evolves with the associated potential for an institution failing versus an approach that focuses on avoiding failure.

An effective regime would also provide the authorities greater latitude to negotiate with creditors and to modify contracts entered into by the company, including contracts that set bonuses and other compensation for management. More generally, we need significant reforms to financial regulation and financial practices that will reduce the risk of future financial crises like the one we are currently experiencing. The Federal Reserve strongly supports such reform efforts.

For a free market system to be succesful, firms must be allowed to fail based upon a predefined set of rules and principles that market participants can rely on when determining their strategies and making decisions.  This is particularly important for financial institutions.  The key principles should apply if we are talking about a small bank in Tulsa or a large financial conglomerate in New York CIty.

I do not mean to imply that regulation should punish firms for being efficient and innovative. Instead, it should offset or remove any advantages to becoming systemically important in the first place, perhaps encouraging some institutions to shrink, become less opaque, or lower their risk profiles.