In a speech delivered to the Council on Foreign Relations, Federal Reserve Chairman Ben Bernanke outlined four steps that he says are necessary to strengthen regulatory oversight of the financial industry.
‘We must have a strategy that regulates the financial system as a whole, in a holistic way, not just its individual components,’ Bernanke said. "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."
Bernanke says the "too big to fail" concept has negative effects. It encourages excessive risk-taking by a company that falls under this consideration and encourages firms to grow for no other reason than to change the perception that they are too small to save. He also says it creates an unlevel playing field for smaller firms.
Such large institutions require stricter regulation, he said, and in the event of their failures, appropriate resolution procedures must be in place to minimize impact. He praised the model used by the Federal Deposit Insurance Corp. in managing failed depositories.
A second component of Bernanke's proposal is to make the financial infrastructure (i.e., institutions that support trading, payments, clearing and settlement) and policy-making more resilient.
"Here, the aim should be not only to help make the financial system as a whole better able to withstand future shocks, but also to mitigate moral hazard and the problem of "too big to fail' by reducing the range of circumstances in which systemic stability concerns might prompt government intervention," he said.
Bernanke called for a review of accounting rules and to "overly magnify the ups and downs in the financial system and the economy."
"There is some evidence that capital standards, accounting rules and other regulations have made the financial sector excessively procyclical – that is, they lead financial institutions to ease credit in booms and tighten credit in downturns more than is justified by changes in the creditworthiness of borrowers, thereby intensifying cyclical changes," Bernanke said.
He also said a macroprudential approach to financial regulation and supervision may be necessary.
"Macroprudential policies focus on risks to the financial system as a whole," he said. "A macroprudential approach would complement and build on the current regulatory and supervisory structure, in which the primary focus is the safety and soundness of individual institutions and markets.
Bernanke suggested that Congress direct a single governmental authority to monitor, assess and address potential systemic risks as to avoid another financial crisis.
SOURCE: Federal Reserve