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Did the layout and navigation of the new site help you locate what you were looking for? Yes No. Do you have any other feedback on the new version of our website? If you are willing to be contacted in the future to help us improve our website, please leave your email address below. 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. 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.
The Federal Reserve, in collaboration with the private sector and other regulators, is intensively engaged in such efforts. For example, since September , the Federal Reserve Bank of New York has been leading a joint public-private initiative to improve arrangements for clearing and settling trades in credit default swaps and other OTC derivatives. These efforts include gaining commitments from private-sector participants to automate and standardize the clearing and settlement process, encouraging improved netting and cash settlement arrangements, and supporting the development of a central counterparty for credit default swaps.
More generally, although customized derivatives contracts between sophisticated counterparties will continue to be appropriate in many situations, on the margin it appears that a migration of derivatives trading toward more-standardized instruments and the increased use of well-managed central counterparties, either linked to or independent of exchanges, could have a systemic benefit.
The Federal Reserve and other authorities also are focusing on enhancing the resilience of the markets for triparty repurchase agreements repos. In the triparty repo market, primary dealers and other large banks and broker-dealers obtain very large amounts of secured financing from money funds and other short-term, risk-averse investors. We are encouraging firms to improve their management of liquidity risk and to reduce over time their reliance on triparty repos for overnight financing of less-liquid forms of collateral.
In the longer term, we need to ensure that there are robust contingency plans for managing, in an orderly manner, the default of a major participant.
We should also explore possible means of reducing this market's dependence on large amounts of intraday credit from the banks that facilitate the settlement of triparty repos.
The attainment of these objectives might be facilitated by the introduction of a central counterparty but may also be achievable under the current framework for clearing and settlement. Of course, like other central banks, the Federal Reserve continues to monitor systemically important payment and settlement systems and to compare their performance with international standards for reliability, efficiency, and safety.
Unlike most other central banks, however, the Federal Reserve does not have general statutory authority to oversee these systems. Instead, we rely on a patchwork of authorities, largely derived from our role as a banking supervisor, as well as on moral suasion, to help ensure that the various payment and settlement systems have the necessary procedures and controls in place to manage the risks they face.
As part of any larger reform, the Congress should consider granting the Federal Reserve explicit oversight authority for systemically important payment and settlement systems. Yet another key component of the software of the financial infrastructure is the set of rules and procedures used to resolve claims on a market participant that has defaulted on its obligations.
In the overwhelming majority of cases, the bankruptcy laws and contractual agreements serve this function well. However, in the rare circumstances in which the impending or actual failure of an institution imposes substantial systemic risks, the standard procedures for resolving institutions may be inadequate. In the Bear Stearns case, the government's response was severely complicated by the lack of a clear statutory framework for dealing with such a situation.
As I have suggested on other occasions, the Congress may wish to consider whether such a framework should be set up for a defined set of nonbank institutions. The implementation of such a resolution scheme does raise a number of complex issues, however, and further study will be needed to develop specific, workable proposals.
A stronger infrastructure would help to reduce systemic risk. Importantly, as my FOMC colleague Gary Stern has pointed out, it would also mitigate moral hazard and the problem of "too big to fail" by reducing the range of circumstances in which systemic stability concerns might be expected by markets to prompt government intervention.
A Systemwide Approach to Supervisory Oversight The regulation and supervisory oversight of financial institutions is another critical tool for limiting systemic risk. Importantly, a well-designed supervisory regime complements rather than supplants market discipline. Indeed, regulation can serve to strengthen market discipline, for example, by mandating a transparent disclosure regime for financial firms.
Going forward, a critical question for regulators and supervisors is what their appropriate "field of vision" should be. Under our current system of safety-and-soundness regulation, supervisors often focus on the financial conditions of individual institutions in isolation. An alternative approach, which has been called systemwide or macroprudential oversight, would broaden the mandate of regulators and supervisors to encompass consideration of potential systemic risks and weaknesses as well.
At least informally, financial regulation and supervision in the United States already include some macroprudential elements. As one illustration, many of the supervisory guidances issued by federal bank regulators have been motivated, at least in part, by concerns that a particular industry trend posed risks to the stability of the banking system as a whole, not just to individual institutions.
For example, following lengthy comment periods, in , the federal banking supervisors issued formal guidance on underwriting and managing the risks of nontraditional mortgages, such as interest-only and negative amortization mortgages, as well as guidance warning banks against excessive concentrations in commercial real estate lending. These guidances likely would not have been issued if the federal regulators had viewed the issues they addressed as being isolated to a few banks.
The regulators were concerned not only about individual banks but also about the systemic risks associated with excessive industry-wide concentrations of commercial real estate or nontraditional mortgages or an industry-wide pattern of certain practices for example, in underwriting exotic mortgages. Note that, in warning against excessive concentrations or common exposures across the banking system, regulators need not make a judgment about whether a particular asset class is mispriced--although rapid changes in asset prices or risk premiums may increase the level of concern.
Rather, their task is to determine the risks imposed on the system as a whole if common exposures significantly increase the correlation of returns across institutions. The development of supervisory guidances is a process which often involves soliciting comments from the industry and the public and, where applicable, developing a consensus among the banking regulators. In that respect, the process is not always as nimble as we might like.
For that reason, less-formal processes may sometimes be more effective and timely. As a case in point, the Federal Reserve--in close cooperation with other domestic and foreign regulators--regularly conducts so-called horizontal reviews of large financial institutions, focused on specific issues and practices. Recent reviews have considered topics such as leveraged loans, enterprise-wide risk management, and liquidity practices. The lessons learned from these reviews are shared with both the institutions participating in these reviews as well as other institutions for which the information might be beneficial.
Like supervisory guidance, these reviews help increase the safety and soundness of individual institutions but they may also identify common weaknesses and risks that may have implications for broader systemic stability. In my view, making the systemic risk rationale for guidances and reviews more explicit is certainly feasible and would be a useful step toward a more systemic orientation for financial regulation and supervision.
Governments have mobilised massive resources in the financial rescue programmes set up in response to the recent financial crisis. This implies that government debt should be maintained at reasonably low levels in good times so that additional debt can be taken on in times of stress without unsettling financial market conditions.
As with monetary policy, it is also important to take into account how fiscal policy affects financial stability. In good times, procyclical policies can serve to heighten complacency and encourage the build-up of financial imbalances. This is even more the case when rapid credit growth and high asset prices flatter the fiscal accounts during the upturn. All this implies that fiscal policy may have to err more on the side of tightness, preparing for the realisation that part of what appears to be sustainable revenues may be subject to a payback.
Of course, this strongly reinforces the case for reducing government debt in relation to GDP in good times.
That said, we should recognise the political economy problem that Adam Smith highlighted in his treatment of the public debt. Lastly, tax policy could be also used to address sectoral developments with potential financial stability implications. We have seen how macroprudential tools can be used to limit excessive credit growth in specific areas such as housing; tax policy could also be of use here. A key way to ensure that the tax code worked for rather than against financial stability would be to reduce or to eliminate its bias towards debt and against equity.
The recent crisis has shown the unfortunate results this bias can have on asset prices and leverage, especially in housing markets. This is not the place to explore in detail how the tax code might be made more even-handed. Suffice it to say that getting rid of the tax incentive to leverage could make a handsome contribution to financial stability.
To summarise, we need to ensure that all public policies - especially monetary, fiscal and macro- and microprudential policies complemented by adequate supervision - become part of a consistent macrofinancial stability framework designed to pre-empt financial excesses and serial boom and bust cycles.
To make this framework effective, careful thought must be given to the institutional setup and to international coordination.
It is crucial to align goals, know-how and control over the various policy instruments, precisely because the responsibilities for financial stability are so widely distributed. The institutional setup should therefore be based on clear mandates and accountability. It will need to rely on close cooperation between central banks and supervisory authorities, both within and across borders. A first open question pertains to the governance structure and flow of information in systemic risk regulation.
The crisis has shown that central banks play a decisive role in systemic regulation. But it is not entirely clear how central banks need to be equipped to play this role.
Especially where the central bank is not the bank supervisor, it is important that the goal be well defined, the instruments understood and the exchange of information with other authorities appropriate - including detailed supervisory information on individual firms.
A second open question is how to balance rules and discretion. In principle, we should rely as far as possible on rules and automatic stabilisers rather than discretion. Rules can help avoid errors that can stem from difficulties in identifying threats to financial stability contemporaneously - dynamic provisioning is a good example of a rule that can help in dealing with procyclicality.
In addition, clear rules can allow the authorities to commit themselves ex ante to responses, thereby facilitating international coordination and enlisting the understanding, and even the anticipation, of market participants.
For instance, market participants, including rating agencies, may not necessarily permit capital and liquidity that is built up in good times to be used in bad times. In this case, clear rules communicated by supervisors will help drawdowns be accepted in the marketplace. Lastly, and perhaps more importantly, rules reduce the enormous political pressures on policymakers to refrain from intervening against booms. However, rules may not be enough: discretion has a role to play as it can help tailor intervention to varying, and often unpredictable, circumstances.
This is why we should accept that some degree of discretion is inevitable. While these open questions have still to be dealt with, I would like to emphasise that important progress has been made in the international coordination of systemic regulation. Indeed, we emerge from the global financial crisis with a brand new structure. The crisis gave further evidence that financial stability cannot be assured by each neighbour keeping his own house in order.
This is necessary but not sufficient. Exposures to a neighbour's losses can bring down one's own house. The Financial Stability Board has taken up a key role in coordinating the work of national authorities and standard setters to ensure international consistency. New mechanisms have been developed to support the development of the IMF-FSB early warning exercises, to increase cooperation across borders and between supervisors, and to conduct peer review exercises.
Comprising both thematic and country by country approaches, such exercises are a new instrument that will strengthen adherence to international standards. Key input into the coordinating work of the Financial Stability Board comes from the expanded Basel Process, which internationally coordinates standard-setting.
Whatever the differences at the national level regarding the scale and scope of financial firms, international agreements on minimum capital and liquidity are being refined. Peer review exercises have been launched to ensure adherence to these standards in each jurisdiction. New institutional arrangements are being explored to enhance cooperation among supervisors both at the national level and across borders.
Let me just mention a few examples. In the case of the biggest firms operating across borders, colleges of supervisors are supplementing the Basel Concordat that sets out the respective roles of home and host supervisors.
Another example, of a different nature, is the proposed European Systemic Risk Board, which will help to coordinate micro and macro approaches and enhance international cooperation. This body would take charge of macroprudential supervision at the European level, issuing risk warnings and making recommendations on policy measures. Lastly, the G20 is playing an increasing role to enhance the necessary coordination of macroeconomic policies and to ensure political support for financial regulatory reform.
The mutual assessment process reinforces the commitment of national leaders to joint and coordinated action. Just as financial stability needs help from monetary and fiscal policy at the national level, international financial stability cannot be achieved in the face of inconsistent policies at the global level. It is very important that leaders remain engaged in and committed to this effort.
No doubt this international structure will continue to evolve. The challenge is to maintain the intimate cooperation that has characterised the Basel Process even as it widens the effort in terms of both participants and issues. As it approaches the end of its 80th year, the Bank for International Settlements pledges to continue its support for this cooperative project to tame systemic risk. The issue of systemic risk is probably the most important and most difficult that we confront.
Progress will require a combination of better regulation, a more macro orientation of prudential tools, better macroeconomic policies, enhanced international coordination and greater market discipline. A lot of work has been done and much progress made.
In some areas, such as capital and liquidity, the convergence of minds has been already substantial. In others, such as the handling of systemically important institutions, work is well under way. Many ideas and proposals are on the table, and we need to make sure that this work does not lose sight of the forest for the trees. The BIS will fully support the Basel Committee and the Financial Stability Board in their comprehensive assessment of the impact of the various proposals to strengthen the financial system before they are implemented.
This assessment will clarify the new regulatory framework and will ensure that the transition to this new and more demanding framework is achieved with minimal interference to the ongoing recovery process.
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BIS Other 12 February Abstract This paper analyses systemic risk and considers appropriate policies to reduce it. Full paper The international financial crisis has made us all think much harder - not only about what systemic risk means, but also about what it means for policy. Concepts of systemic risk 2 As already mentioned, systemic risk has two dimensions, cross-sectional and time. A shock may take two main forms: The financial system is a network of interconnected balance sheets.
As a result, an increasingly complex web of daily transactions means that a shock hitting one institution can spread to the other institutions that are connected to it and become systemic. The Herstatt and Continental Illinois crises both started with problems in one specific financial institution. Because of settlement and interbank linkages, the failure of each of these specific firms threatened wider problems for connected institutions that were otherwise sound.
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