William Dudley, President and Chief Executive Officer of the Federal Reserve Bank of New York, spoke again Tuesday in Asia on Regulatory Reform of the Global Financial System. Dudley explains, "The financial crisis exposed significant vulnerabilities in the financial system. Without revisiting all the causes and consequences of the credit boom and bust that led to a boom and bust in the U.S. housing market, the bottom line is that our regulatory system failed in two important dimensions. First, a significant number of large, internationally active financial firms reached the brink of failure. Second, the financial system was not very resilient when these firms got into difficulty. Instead, the threat of failure propagated further shocks that reverberated throughout the global financial system."

He says, "These two shortcomings reflect many factors including inadequate capital and liquidity buffers, poor incentives to correctly measure, price and manage risks ex ante, the opacity of firm balance sheet and counterparty exposures, and the manner in which large financial firms were interconnected within the financial system. In the end, there was too much leverage in which large amounts of highly illiquid, long-term assets were financed by short-term liabilities. The fact that a large amount of the wholesale funding used to finance these assets was provided by leveraged financial intermediaries to other financial intermediaries increased the system's vulnerability to adverse shocks. As it turned out, the amount and quality of capital was grossly inadequate relative to the quality of the assets and off-balance-sheet exposures of many of the major global banking institutions. Moreover, many institutions had inadequate liquidity buffers. The lack of liquidity forced the fire sale of assets, which depressed prices and increased the pressure on capital."

Dudley continues, "The interconnectedness of the financial system also caused shocks to spread quickly. For example, the failure of Lehman Brothers led to losses at the Reserve Fund, which precipitated a widespread money market mutual fund panic. It also led to actions by U.K. bankruptcy authorities that had the effect of freezing the assets owned by hedge fund and other clients of the firm and this encouraged such investors to pull assets from other institutions perceived to be weak. These and other propagation channels in turn, led to virtual stoppage of lending and borrowing activity in the money markets and, ultimately, a credit crunch that reverberated throughout the global financial system. For example, the crisis led to a sharp constraint on the availability of trade credit in the fall of 2008 that had a devastating impact on economic activity in emerging markets in Asia and Latin America, as well as Japan. This region felt the full economic consequences of the crisis even though banks in the region were generally healthy and far from the U.S. housing boom and bust and the subprime mortgage debacle that could be viewed as the initial spark that ignited the crisis."

He comments, "The crisis also underscored another area for further cross-border work: Our international approach to liquidity provision and lender-of-last-resort services to globally active institutions. Cooperation among liquidity providers, for example, through some central bank dollar swap arrangements, played an important role in stabilizing global money markets. However, the division of lender-of-last-resort responsibilities between home and host countries remained ambiguous through the crisis. This needs further attention."

Dudley asks, "So what steps have been taken to address some of these sources of vulnerability? There are literally dozens of initiatives underway nationally and globally, not only in traditional bodies for such cooperation such as the Basel Committee on Bank Supervision, but also among newer international groups such as the Financial Stability Board. Most of these initiatives can be grouped into three major categories: Actions to significantly reduce the probability of failure of large systemically important financial institutions. Measures to broaden the oversight of the financial system to include activities that occur outside of the core banking system. The shadow banking system, which is composed of the wide range of financial intermediation activities that occur outside of the traditional purview of bank regulators, needs greater attention."

He continues, "In particular, shadow banking activities that involve maturity transformation are vulnerable to shocks because such activities do not have the support of bank deposit guarantees or access to central bank liquidity and, thus, are vulnerable to funding runs. Steps to strengthen the resolution regime and the core financial market infrastructure to ensure that when a large complex financial firm fails, the failure doesn't threaten to bring down the entire financial system."

Dudley then says, "The second important strand of reform is to ensure that regulatory oversight is sufficiently broad to include the activities of the so-called shadow banking system. This aspect of reform and oversight is still in its early days. But work is underway. For example, the Financial Stability Board is undertaking work to identify potential sources of vulnerability caused by the activities in the shadow banking system and how such vulnerabilities could be addressed. Also, in the United States, the Financial Stability Oversight Council (FSOC) views its mandate broadly with respect to identifying systemic risks and proposing remedies. For example, on an ongoing basis, the FSOC will monitor and assess which non-bank financial intermediaries in the United States are systemically important and, thus, require greater regulatory oversight."

Finally, he adds, "But the focus will not just be on large financial firms. Activities and practices that occur outside of the core institutions are also important. For example, the activities of money market mutual funds is one area receiving close scrutiny. As you know, a run on the money market funds developed in the fall of 2008 when the Reserve Fund broke the buck when Lehman Brothers failed. This underscored a critical structural weakness of money market mutual funds created by the convention that the net stable asset value could be fixed at par. When a money market mutual fund incurs losses that cause it to 'break the buck,' this encourages investors to rush to withdraw their funds from other funds before they break the buck. The result can be a run on money market mutual fund assets. In the United States, the Securities Exchange Commission has already tightened the rules with respect to liquidity, quality and the average maturity of so-called 2a-7 fund assets, but there is still more to be done to address the remaining vulnerabilities."

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