A regulatory structure more focused on the financial system as a whole, rather than individual institutions, is key to ensuring future financial stability, Federal Reserve Chairman Ben Bernanke said Thursday.
Speaking at the Federal Reserve Bank of Chicago's 45th annual Conference on Bank Structure and Competition in Chicago, Bernanke explained why reform of the current regulatory system is necessary.
Bernanke noted that an approach to supervision that focuses narrowly on individual institutions can miss broader problems that are building up in the system, and insisted that the stress test recently performed on major lenders has been comprehensive, rigorous, forward-looking, and highly collaborative.
The stress test results, expected at 5 pm ET, will lay out how much more capital banks might be required to raise in order to satisfy the new stringent capital requirements. Each of the nineteen institutions will be rated for their ability to weather various economic scenarios.
Leaked reports have suggested that most of the financial companies examined by the government do not need additional capital. Last night on television, Treasury Secretary Timothy Geithner assured that none of the country's biggest banks are insolvent.
Still, Bernanke called for a more macroprudential approach to supervision, looking at the entire financial system as well as individual institutions. In theory, such an approach will mitigate the potential domino effect seen in the current financial crisis.
For example, under a system-focused regulatory structure something like the boom of the subprime mortgage market - which many believe to be the catalyst for the current crisis - would be assessed for potential systemic risks rather than the risks to individual institutions.
In addition, the supervision would analyze potential spillover scenarios, including the mutual exposures of highly interconnected firms.
Such a structure would also provide a resolution mechanism for institutions considered too big to fail, therefore mitigating the devastating effects of the outright collapse of a highly connected financial institution.
The financial crisis revealed weakness in both risk management in the private sector as well as the current regulatory structure, Bernanke said. Although it is necessary to reform the current system, he rejected the notion that the current framework should be expunged.
Bernanke predicted that liquidity and risk management will be just as important as capital in terms of regulatory practices.
Liquidity and firm-wide risk management are going to get more attention and equal weight to capital, he said. In terms of the higher emphasis on capital.that was the approach taken before the crisis.
In his remarks, Bernanke noted that the Federal Reserve has been revisiting its policies on capital.
Specifically, he offered details on the stress test methodology, including the fact that over 150 examiners, supervisors, and economists from the Fed, Office of the Comptroller of the Currency, and the Federal Deposit Insurance Corporation, helped in the review and evaluation of the capital of the 19 major institutions subject to the stress tests.
As we have learned over the past year and a half, adequate liquidity management entails more than holding assets that are liquid in normal times; firms must take into account how their liquidity positions might fare under stressed market conditions, the Fed Chairman said.
Briefly, Bernanke addressed the front-loaded compensation structure which many cite as an underlying cause for the financial crisis, encouraging risky behavior on all levels that leads to a highly leveraged financial system.
Bonuses and other compensation should provide incentives for employees at all levels to behave in ways that promote the long-run health of the institution, Bernanke said. Certainly, an important lesson of the crisis is that the structure of compensation and its effect on incentives for risk-taking is a safety-and-soundness issue.
In the question and answer portion of the speech, Bernanke addressed concerns over how the Federal Open Market Committee will unwind the various lending facilities it established to inject liquidity into frozen credit markets. He assured the audience that the FOMC has spent an enormous amount of time pondering the programs, examining their effects and ultimately the best way to get rid of them.
All of the programs are designed to facilitate a return of credit availability to fully private hands as quickly as possible, Bernanke said. Many of the programs will wind down naturally as the markets recover. The Fed made the facilities' pricing unattractive in normal functioning markets, with the thinking that as markets recover institutions will stop using the Fed's facilities in favor of more attractively priced lending.
This has already been seen in the FOMC's commercial paper and other facilities, Bernanke noted, stating that demand has declined as market conditions improved.
The Fed Chairman did not comment on the economic outlook in his remarks.
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