This is necessary, of course, because a series of regulatory regimes that appear best for each individual country would likely be distinctly second-best or even worse when considered collectively. The recent crisis underscores the fact that the regulatory regime needs to be harmonized and global in nature. My second concern on the regulatory reform front is that reform may be too focused on the traditional banking sector and not enough on other financial intermediation activities. Of course, it is clear that we need to make the traditional banking system more resilient and robust. 2 But make no mistake, we also need to ensure that regulatory reform fully encompasses the full range of financial intermediation activity, including capital markets and insurance, over-the-counter (OTC) trading of securities and derivatives, wholesale collateralized funding markets, and payments and settlements. This is necessary for two reasons. First, too much focus on raising the requirements on banks runs the risk of just forcing activity into the non-banking sector. Second, many of the problems of the financial crisis originated outside of the banking sector.
Macroprudential supervision, which I characterize as the top-down assessment of risks throughout the financial system, is essential because it addresses the problem of gaps in the regulatory regime and the regulatory arbitrage that such gaps can encourage. In addition, macroprudential supervision is needed because the financial system is interconnected. As amply demonstrated during the crisis, siloed regulatory oversight is problematic. Supervisory practices must be revamped so that supervision is also horizontal – looking broadly across banks, nonbanks, capital markets, payment and settlement systems and geographies. In the United States, the Federal Reserve is well suited to play a major role in such oversight because it alone has the expertise in three major aspects of the financial system – banking, capital markets, and payments and settlement systems. It also currently has oversight responsibility for most of the firms that one would view as systemically important. In evaluating what the Federal Reserve should do, it is important to recognize that the Federal Reserve’s three primary roles – monetary policy, the lender of last resort function, and supervision – are closely interlinked. Each one of these activities helps the Federal Reserve perform the others. For example, the information we collect as part of the supervisory process gives us a frontline, real-time view of the state of the financial industry and broader economy. Monetary policy is more informed as a result. Only with this knowledge can a central bank understand how the monetary policy impulse will be propagated through the financial system and affect the real economy.