At a speech on Friday at a conference hosted by the Council on Foreign Relations, Federal Reserve Bank of New York President William C. Dudley reviewed the roots of the current financial and economic crisis and prescriptions for recovery. He reviewed initiatives currently underway to provide direct liquidity to borrowers, such as the Commercial Paper Funding Facility, and to restart the securitization markets, though the Term Asset-Backed Securities Loan Facility (TALF), which "provides balance sheet capacity to risk capital that cannot currently get leverage." He noted that the TALF "is being rolled out in two stages" with "TALF 2.0" covering "new asset classes such as Commercial Mortgage Backed Securities." Although "development of this phase is still in its early days, ... it [is] anticipated that the size and scope of TALF will expand sharply in the months ahead."

He emphasized the importance of Treasury's announced Capital Assistance Program, with mandatory stress tests for the largest banking organizations, as a means of breaking "the adverse dynamic" in which banks "don’t have an incentive to raise sufficient capital to ensure that they can handle a very bad outcome," which can leave banks "undercapitalized in a stress environment" and can make "these banks (and their counterparties) very cautious in terms of their behavior. This cautiousness, which is rational for each bank and counterparty individually, is bad for the system because it constrains the supply of credit and results in tighter financial conditions." In his view, the stress test and CAP funding "should help to break this dynamic," which "should reassure banks and investors that the banking system will remain resilient" and lead to more lending, which "in turn, should reduce the likelihood that the bad economic scenario will, in fact, be realized." He concluded his remarks by setting forth seven areas requiring focus:

  • More transparency and homogeneity in securities, noting that the "difficulty in valuing opaque and heterogeneous securities has led to greater illiquidity, price volatility and market risk, bigger haircuts and more forced deleveraging" and "undue reliance on credit ratings."
  • Central counterparties (or CCPs) for over-the-counter derivatives to reduce settlement risk, which requires coordination "with international supervisors, regulators, and governments to achieve global solutions."
  • An accounting and disclosure regime that "allows investors to meaningfully ascertain the risks they are taking."
  • Legislation establishing a "resolution mechanism" for bank holding companies and non-bank financial institutions "that is robust and transparent so everyone understands the rules of the road and likely outcomes beforehand."
  • An "explicit quid pro quo" for large systemically important institutions that are too big to fail.
  • A more robust capital regime for banks, addressing "real-time market-based measures of capital and risk" and the reassessing the "amount of reserves they can build in good times as a buffer against cyclical downturns."
  • A "more effective regulatory system" that includes "a systemic risk authority that has both the responsibility and the powers to look across the entire financial system—both depository institutions and the capital markets."