An overhaul of how the government regulates the financial system is required to prevent future economic crises, said US Federal Reserve chairman Ben Bernanke in a speech delivered before the Council of Foreign Relations in Washington today.
During the speech he outlined the principles that should guide regulatory reform, saying: "We must have a strategy that regulates the financial systems as a whole, in a holistic way, not just its individual components. In particular, strong and effective regulation and supervision of banking institutions, although necessary for reducing systemic risk, are not sufficient by themselves to achieve this aim."
He noted four specific areas that require attention: the problem of large, interconnected financial firms; financial infrastructure - including the processes that govern trading, payment, clearing and settlement in financial markets; regulatory and accounting policies; and the need to address systemic risks under one authority.
While admitting that the government has the responsibility to step in and save a financial institution whose failure would pose a systemic risk, he also warned that the market belief that some firms are too big to fail "reduces market discipline and encourages excessive risk-taking by the firm".
He stated that, while the US government would remain committed to supporting these institutions to mitigate further disruption to financial markets, it should also try to prevent firms from taking on excessive risks.
"Any firm whose failure would pose a systemic risk must receive especially close supervisory oversight of its risk-taking, risk management and financial condition, and to be held to high capital and liquidity standards," he noted.
Seeking to address risks in the commercial paper market, Bernanke also called for tighter restrictions on the sort of instruments money market mutual funds invest in. He highlighted the New York-based Reserve Primary fund, a money market mutual fund that fell below $1.00 in net asset value (NAV) on September 16 due to its exposure to Lehman Brothers' commercial paper.
Bernanke also praised the Fed's March 4 approval of IntercontinentalExchange's (Ice) membership of the Federal Reserve System, a key step in the subsequent launch of Ice's central clearing platform for credit default swaps (CDS), noting that "the infrastructure for managing these derivatives is still not as efficient or transparent as that for more mature investments".
But he blamed accounting regulations and capital requirement rules for leading financial institutions "to ease credit in booms and tighten credit in downturns more than is justified by changes in the credit-worthiness of borrowers, thereby intensifying cyclical changes".
In the current crisis, he added, capital requirements have increased at a time when capital is hardest to raise, intensifying the pressure on banks. This has also led them to reduce new lending activity in order to raise more capital.
He also suggested that the US adopt a "macroprudential" approach to financial regulation and supervision by surveying risk as a whole and called for the creation of a single authority to oversee these risks.
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