Ben Bernanke gave a speech today in Jackson Hole on “Reducing Systemic Risk”
Here are some parts and a full text link the end.
On Bear Stern episode:
“An effective means of increasing the resilience of the financial system is to strengthen its infrastructure. For my purposes today, I want to construe “financial infrastructure” very broadly, to include not only the “hardware” components of that infrastructure–the physical systems on which market participants rely for the quick and accurate execution, clearing, and settlement of transactions–but also the associated “software,” including the statutory, regulatory, and contractual frameworks and the business practices that govern the actions and obligations of market participants on both sides of each transaction. Of course, a robust financial infrastructure has many benefits even in normal times, including lower transactions costs and greater market liquidity. In periods of extreme stress, however, the quality of the financial infrastructure may prove critical. For example, it greatly affects the ability of market participants to quickly determine their own positions and exposures, including exposures to key counterparties, and to adjust their positions as necessary. When positions and exposures cannot be determined rapidly–as was the case, for example, when program trades overwhelmed the system during the 1987 stock market crash–potential outcomes include highly risk-averse behavior by market participants, sharp declines in market liquidity, and high volatility in asset prices. The financial infrastructure also has important effects on how market participants respond to perceived changes in counterparty risk. For example, during a period of heightened stress, participants may be willing to provide liquidity to a market if a strong central counterparty is present but not otherwise.
Considerations of this type were very much in our minds during the Bear Stearns episode in March. The collapse of Bear Stearns was triggered by a run of its creditors and customers, analogous to the run of depositors on a commercial bank. This run was surprising, however, in that Bear Stearns’s borrowings were largely secured–that is, its lenders held collateral to ensure repayment even if the company itself failed. However, the illiquidity of markets in mid-March was so severe that creditors lost confidence that they could recoup their loans by selling the collateral. Many short-term lenders declined to renew their loans, driving Bear to the brink of default.
Although not an extraordinarily large company by many metrics, Bear Stearns was deeply involved in a number of critical markets, including (as I have noted) markets for short-term secured funding as well as those for over-the-counter (OTC) derivatives. One of our concerns was that the infrastructures of those markets and the risk- and liquidity-management practices of market participants would not be adequate to deal in an orderly way with the collapse of a major counterparty. With financial conditions already quite fragile, the sudden, unanticipated failure of Bear Stearns would have led to a sharp unwinding of positions in those markets that could have severely shaken the confidence of market participants. The company’s failure could also have cast doubt on the financial conditions of some of Bear Stearns’s many counterparties or of companies with similar businesses and funding practices, impairing the ability of those firms to meet their funding needs or to carry out normal transactions. As more firms lost access to funding, the vicious circle of forced selling, increased volatility, and higher haircuts and margin calls that was already well advanced at the time would likely have intensified. The broader economy could hardly have remained immune from such severe financial disruptions. Largely because of these concerns, the Federal Reserve took actions that facilitated the purchase of Bear Stearns and the assumption of Bear’s financial obligations by JPMorgan Chase & Co.
This experience has led me to believe that one of the best ways to protect the financial system against future systemic shocks, including the possible failure of a major counterparty, is by strengthening the financial infrastructure, including both the “hardware” and the “software” components.”
On regulation:
“A systemwide focus for financial regulation would also increase attention to how the incentives and constraints created by regulations affect behavior, especially risk-taking, through the credit cycle. During a period of economic weakness, for example, a prudential supervisor concerned only with the safety and soundness of a particular institution will tend to push for very conservative lending policies. In contrast, the macroprudential supervisor would recognize that, for the system as a whole, excessively conservative lending policies could prove counterproductive if they contribute to a weaker economic and credit environment. Similarly, risk concentrations that might be acceptable at a single institution in a period of economic expansion could be dangerous if they existed at a large number of institutions simultaneously. I do not have the time today to do justice to the question of the procyclicality of, say, capital regulations and accounting rules. This topic has received a great deal of attention elsewhere and has also engaged the attention of regulators; in particular, the framers of the Basel II capital accord have made significant efforts to measure regulatory capital needs “through the cycle” to mitigate procyclicality. However, as we consider ways to strengthen the system for the future in light of what we have learned over the past year, we should critically examine capital regulations, provisioning policies, and other rules applied to financial institutions to determine whether, collectively, they increase the procyclicality of credit extension beyond the point that is best for the system as a whole.
A yet more ambitious approach to macroprudential regulation would involve an attempt by regulators to develop a more fully integrated overview of the entire financial system. In principle, such an approach would appear well justified, as our financial system has become less bank-centered and because activities or risk-taking not permitted to regulated institutions have a way of migrating to other financial firms or markets. Some caution is in order, however, as this more comprehensive approach would be technically demanding and possibly very costly both for the regulators and the firms they supervise. It would likely require at least periodic surveillance and information-gathering from a wide range of nonbank institutions. Increased coordination would be required among the private- and public-sector supervisors of exchanges and other financial markets to keep up to date with evolving practices and products and to try to identify those which may pose risks outside the purview of each individual regulator. International regulatory coordination, already quite extensive, would need to be expanded further.”
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