This means (1) a system in which the major institutions are less vulnerable to shocks; (2) a system that is less vulnerable to margin spirals and a generalized pull-back in liquidity and funding; and (3) a system that is more able to withstand the effects of failure of a major financial institution. Looking past the immediate crisis, a more resilient system must be built on stronger and better designed shock absorbers, both in the major institutions and in the infrastructure of the financial system. At the level of the financial institution, the key financial shock absorbers are capital and reserves, margin and collateral, liquidity, and the risk management and control regime. Financial stability starts with ensuring that individual institutions in periods of expansion and relative stability hold adequate resources against the losses and liquidity pressures that can emerge in economic contraction or instability. For the infrastructure of the financial system, these shock absorbers include the resources held against the risk of default by a major market participant across the set of private sector and cooperative arrangements for the funding, trading, clearing and settlement of financial transactions. Simplifying and consolidating the regulatory architecture will be instrumental to these efforts by establishing a common framework of rules, clear responsibility and authority, and by reducing opportunities for arbitrage. Through close coordination across central banks, supervisors and market regulators, we need to adopt an integrated approach to the design and enforcement of capital standards and other prudential regulations critical to systemic stability.
In this context, prudential supervisors, working with those responsible for setting accounting standards and capital market regulations, need to systematically examine the interaction among capital, accounting, tax and disclosure requirements to assess their effects on the overall levels of leverage and risk across the financial system. As we change the framework of regulation and oversight, we need to find ways to strengthen market discipline over financial institutions, and to limit the moral hazard that is present in a range of different forms in any regulated financial system. The liquidity tools of central banks and the emergency powers of other public authorities were created in recognition of the fact that individual institutions, including those central to payments and funding mechanisms, cannot protect themselves fully from an abrupt evaporation of access to liquidity or ability to liquidate assets. The existence of these tools and their use in crises, however appropriate, creates moral hazard by encouraging market participants to engage in riskier behavior than they would have in the absence of the central bank’s backstop. To mitigate this effect on risk-taking, strong supervisory authority is required over the consolidated financial entities that are critical to a well-functioning financial system. A more resilient financial system will also require a framework for dealing with the failure of financial institutions. For entities that take deposits, we have a formal resolution framework in place.