Fed Chairman Unveils Report on 'Appropriate Responses' to Financial Crisis

(June 16 Speech by Federal Reserve Chairman Ben Bernanke)

The Squam Lake Report is a valuable contribution to the ongoing analysis of the causes of the financial crisis and the appropriate policy responses...I think we all agree on the key questions facing financial regulators: How do we strengthen the financial system and its oversight so as to minimize the risk of a replay of the recent financial crisis? And should a crisis occur, how can we limit its economic costs?

The report identifies two core principles that should be among those that guide us in answering these questions. First, financial policymakers and supervisors must consider more than the safety and soundness of individual financial institutions, as important as that is; they should also consider factors, including interactions of institutions and markets, that can affect the stability of the financial system as a whole. In the jargon of economists and regulators, supervisors need a macroprudential as well as a microprudential perspective.

The second core principle put forth in the report is that the stakeholders in financial firms--including shareholders, managers, creditors, and counterparties--must bear the costs of excessive risk-taking or poor business decisions, not the public. The perception that some institutions are "too big to fail"--and its implication that, for those firms, profits are privatized but losses are socialized--must be ended.

The Federal Reserve strongly agrees with both of these principles, and both have been important in shaping our views on regulatory reform. We also broadly agree with the narrative of the crisis offered in the report, which discusses, among other things, the role of subprime lending in the housing boom and bust; the structural weaknesses in the shadow banking system, including insufficient transparency and investor overreliance on rating agencies; inadequate risk management by many financial institutions; and a flawed regulatory framework that allowed some large financial firms to escape strong consolidated supervision and gave no regulator the mandate or powers needed to effectively evaluate and respond to risks to the financial system as a whole. Weaknesses in both the private sector and the public sector, in the framework for regulation, and in supervisory execution all contributed to the crisis. The crisis in turn led to a severe tightening of credit, a collapse in confidence, and a sharp global economic downturn.

The Squam Lake Recommendations
What, then, is to be done? The Squam Lake Report provides a substantial set of recommendations. Among these are the adoption of a more systemic approach to the supervision and regulation of financial firms and markets; enhanced capital and liquidity regulation for financial firms, particularly for systemically important institutions; improved information collection by regulators and, where possible, the public release of such information; development of a resolution regime that would allow the authorities to manage the failure of a systemically important financial firm in an orderly manner while imposing losses on shareholders and creditors; and significant strengthening of the financial infrastructure, particularly for derivatives contracts. The Federal Reserve has supported legislative changes in all of these areas, and, where possible under current law, has initiated changes along these lines within its own operations. In the remainder of my remarks I will elaborate briefly on these recommendations, with particular attention to how they are currently helping shape regulatory reform and the Fed's own regulatory and supervisory activities...

For the full speech and specific suggestions for action, visit http://www.federalreserve.gov/newsevents/speech/bernanke20100616a.htm.

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