Federal Reserve Vice Chair Janet L. Yellen spoked Friday on the "Interconnectedness and Systemic Risk: Lessons from the Financial Crisis and Policy Implications." She says, "In my remarks, I will discuss a few of the major regulatory and supervisory changes under way to address the potential for excessive systemic risk arising from the complexity and interconnectedness that characterize our financial system. The design of an appropriate regulatory framework entails tradeoffs between costs and benefits.... I am quite aware that some reforms in the wake of the financial crisis, including those pertaining to derivatives, have been controversial. In connection with recent rulemakings--and, more broadly, in the arena of public debate--critics have asked whether complexity and interconnectedness should be treated as potential sources of systemic risk. This is a legitimate question that the Federal Reserve welcomes and itself seeks to answer in its roles of researcher, regulator, and supervisor. Let me say at the outset, though, that a lack of complete certainty about potential outcomes is not a justification for inaction, considering the size of the threat encountered in the recent crisis.... Enhanced capital standards for GSIBs serve to limit the risks undertaken by the largest, most interconnected institutions whose distress has the greatest potential to impose negative externalities on the broader financial system. A framework of higher minimum regulatory capital standards for these institutions was issued by the Basel Committee in November 2011, and indicators of interconnectedness account for a significant proportion of the overall score used to determine whether a bank will be subject to higher standards. As shown by Gai, Haldane, and Kapadia, among others, highly interconnected firms can transmit shocks widely, impairing the rest of the financial system and the economy. We saw, for example, that when Lehman Brothers failed, the shock was transmitted through money market mutual funds to the short-term funding and interbank markets. While some participants in each of these sectors had direct exposures to Lehman, many more did not. Moreover, even in cases in which direct exposures to Lehman were manageable, the turmoil caused by Lehman's failure added stress to the system at a particularly unwelcome time. In this way, the failure of a highly interconnected institution such as Lehman imposes costs on society well in excess of those borne by the firm's shareholders and direct creditors. Accordingly, tying enhanced capital requirements to interconnectedness improves the resilience of the system. Of course, higher capital requirements are not costless; they may raise financing costs for some borrowers, and they have the potential to induce institutions to engage in regulatory arbitrage. An important ongoing agenda for research and policy is the design and implementation of data-based measures of interconnectedness to ensure that our understanding of financial system interconnections evolves in tandem with financial innovation."

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