This morning, Federal Reserve Chairman Ben S. Bernanke spoke before the Council on Foreign Relations as part of a series of meetings on international economics. Chairman Bernanke's speech focused on the need for regulatory overhaul given the severity of the existing global economic crisis. He said that the "[r]isk-management systems of the private sector and government oversight of the financial sector in the United States and some other industrial countries failed to ensure" proper investment of capital, which has led to "[a] powerful reversal in investor sentiment and a seizing up of credit markets."

Chairman Bernanke described four key elements of a strategy to reform the existing financial architecture that "[c]ould help prevent a similar crisis from developing in the future":

  1. Too Big to Fail - Chairman Bernanke suggested a new "resolution regime" to better supervise "large, interconnected financial firm[s]" to prevent excessive risk-taking and creating, for all "systemically critical firms," "clear guidelines" regarding the following:  
  • Addressing the weaknesses at major financial institutions in capital adequacy, liquidity management, and risk management that have been revealed by the crisis, including insisting that large financial firms be capable of monitoring and managing their risks in a timely manner and on an enterprise-wide basis.
  • Ensuring a robust framework for consolidated supervision of all systemically important financial firms organized as holding companies, with "[c]lear authority to monitor and address safety and soundness concerns in all parts of the organization." Such an application would help "[e]liminate gaps in oversight that would otherwise allow risk-taking to migrate from more-regulated to less-regulated sectors."
  • Improving the resolution of systemically important nonbank financial firms, other than through the federal bankruptcy laws, given that "[t]his framework does not sufficiently protect the public's strong interest in ensuring the orderly resolution of nondepository financial institutions when a failure would pose substantial systemic risk."
  1. Strengthening the Financial Infrastructure - Chairman Bernanke next focused on reducing the range of circumstances in which systemic stability concerns might prompt government intervention. Chairman Bernanke suggested:
  • Improving the infrastructure of the clearing and settling of credit default swaps (CDS) and other over-the-counter derivatives, such as the recent approval of the application for membership in the Federal Reserve System of ICE Trust, a trust company that proposes to operate as a central counterparty and clearinghouse for CDS transactions.
  • Considering a "central clearing system" for the triparty repurchase agreement (repo) market which was stabilized only after the Federal Reserve, under its emergency powers, launched the Federal Reserve's Primary Dealer Credit Facility following the collapse of Bear Stearns and later expanded after the Lehman bankruptcy.
  • Granting the Federal Reserve "[e]xplicit oversight authority for systemically important payment and settlement systems," much like other major central banks around the world.
  • Imposing tighter restrictions on the instruments in which money market mutual funds can invest, potentially requiring shorter maturities and increased liquidity, given the crucial role such funds play as a key source of funding for many businesses.
  1. Procyclicality in the Regulatory System - Chairman Bernanke acknowledged that various regulatory and supervisory policies may be putting "[u]njustified pressure on financial institutions." For example, capital regulations should be "forward-looking" so that reduced lending may be appropriate even during economic downturns when a financial institution would otherwise find capital raising to be difficult. In addition, current accounting standards "warrant further review," given that existing valuation and loss provisioning standards make it difficult to determine appropriate valuation methods for illiquid assets, and the creation of appropriate loan loss reserves.
  2. Systemic Risk Authority - Finally, Chairman Bernanke floated the idea of introducing "macroprudential" policies focusing on risks to the financial system as a whole. Chairman Bernanke suggested that Congress create a "[g]overnmental authority to monitor, assess, and, if necessary, address potential systemic risks within the financial system," with the mission to: (A) monitor large or rapidly increasing exposures (i.e subprime mortgages) across firms and markets, rather than only at the level of individual firms or sectors; (B) assess the potential for deficiencies in evolving risk-management practices, broad-based increases in financial leverage, or changes in financial markets or products to increase systemic risks; (C) analyze possible spillovers between financial firms or between firms and markets, such as the mutual exposures of highly interconnected firms; and (D) identify possible regulatory gaps that pose risks for the system as a whole.

During the question and answer period, Chairman Bernanke stated that, with respect to those proposals where legislation is required, the Federal Reserve is seeking legislation on its "own account," as well as in consultation with the Treasury and the existing administration. In addition, the Chairman spent a few minutes comparing the Federal Reserve today with the Federal Reserve during the Great Depression, noting that, during the Great Depression, the "Federal Reserve didn't understand what was going on, and pursed very orthodox policies constrained by the gold standard, effectuating a very powerful deflation which was extremely damaging." Finally, in response to when he thinks the recession will end, Chairman Bernanke emphasized that it critically depends on getting the banking and financial system reasonably stabilized, "[w]ith a good chance the recession will end later this year and that 2010 will be a period of growth."