Image of Seal of the Board of governors 

of THE 

FEDERAL RESERVE SYSTEM 

washington, D. C. 2055 I 

January 13, 2010 ben s. BERNANK E 

CHAIRMA N 

The Honorable Christopher J. Dodd 

Chairman 

Committee on Banking, Housing, 

and Urban Affairs 

United States Senate 

Washington, D.C. 20510 

The Honorable Richard C. Shelby 

Ranking Member 

Committee on Banking, Housing, 

and Urban Affairs 

United States Senate 

Washington, D.C. 20510 

Dear Chairman Dodd and Ranking Member Shelby; 

Strengthening our financial regulatory system in ways that take the appropriate 

lessons from the crisis is essential for the long-term economic stability of our country. 

To this end, as you know, the Banking Committee has compiled an extensive hearing 

record and has begun considering specific reform proposals. 

A number of your colleagues on the Committee have recently asked for the 

Board's views on the importance of the Federal Reserve's continued role in bank 

supervision and regulation. In response to these requests, I am enclosing for you and 

your colleagues a document that discusses (1) how the expertise and information that the 

Federal Reserve develops in the making of monetary policy enable it to make a unique 

contribution to an effective regulatory regime, especially in the context of a more 

systemic approach to consolidated oversight; and (2) how active involvement in 

supervising the nation's banking system allows the Federal Reserve to better perform its 

critical functions as a central bank. 

Please let me know if you have any questions or if I can be of assistance. I look 

forward to working with you in the days ahead as the Committee continues its 

consideration of regulatory reform proposals. 

Sincerely, 

[signature of] Ben Bernanke 

Enclosure 

cc: Members, Committee on Banking, Housing, and Urban Affairs 
January 13, 2010 

The Public Policy Case for a Role 

for the Federal Reserve in Bank Supervision and Regulation 

Like many other central banks around the world, the Federal Reserve participates with other 

agencies in supervising and regulating the banking system. The Federal Reserve’s involvement 

in supervision and regulation confers two broad sets of benefits to the country. 

First, the financial crisis has made clear that an effective framework for financial supervision 

and regulation must address both safety-and-soundness risks at individual institutions and 

macroprudential risks--that is, risks to the financial system as a whole. All individual financial 

institutions that are so large and interconnected that their failure could threaten the functioning of 

the financial system must be subject to strong consolidated supervision. Both effective 

consolidated supervision and addressing macroprudential risks require a deep expertise in the 

areas of macroeconomic forecasting, financial markets, and payments systems. As a result of its 

central banking responsibilities, the Federal Reserve possesses expertise in those areas that is 

unmatched in government and that would be difficult and costly for another agency to replicate. 

Second, the Federal Reserve’s participation in the oversight of the banking system significantly 

improves its ability to carry out its central banking functions. Most importantly, the Federal 

Reserve’s ability to effectively address actual and potential financial crises depends critically on 

the information, expertise, and powers that it gains by virtue of being both a bank supervisor and 

a central bank. In addition, supervisory information and expertise significantly enhance the 

safety and soundness of the credit the Federal Reserve provides to depository institutions by 

allowing the Federal Reserve to independently evaluate the financial condition of institutions that 

want to borrow from the discount window as well as the quality and value of the collateral 

pledged by such institutions. Finally, its supervisory activities provide the Federal Reserve 

information about the current state of the economy and the financial system that, particularly 

during periods of financial crisis, is valuable in aiding the Federal Reserve to determine the 

appropriate stance of monetary policy. These benefits of the Federal Reserve’s supervisory role 

proved particularly important during the financial crisis that emerged in 2007. 

We recognize, of course, that bank supervision, including ours, needs to be more effective than 

in the past, and we have reviewed our performance and are making improvements at multiple 

levels. The Federal Reserve is working with other supervisors here and abroad to improve 

capital and liquidity regulation. In addition, we have begun to make changes to our oversight of 

large banking organizations, including the development of an enhanced quantitative surveillance 

program, improving data collection, strengthening financial infrastructure, and implementing a 

new, centralized approach to supervision that better supports identification and analysis of 

interconnected risks. These changes are intended to ensure that we fully employ our expertise to 

implement a more systemic and effective approach to our supervisory activities going forward. 
The Benefits to Effective Supervision of the Federal Reserve’s Unique Expertise 

Two important lessons learned from the current financial crisis are that all financial firms that are 

so large and interconnected that their failure could threaten the functioning of the financial 

system must be subject to strong consolidated supervision; and that supervision of financial firms 

must take account of systemic, or “macroprudential” risks as well as the more traditional safetyand-soundness risks affecting individual firms. 

Many of the large, complex, and interconnected financial firms whose collapse contributed 

importantly to the financial crisis avoided the more stringent consolidated supervision that is 

imposed on bank holding companies by the Federal Reserve. These firms--which included 

American International Group, Washington Mutual, Countrywide, Bear Stearns, and Lehman 

Brothers--were instead subject to consolidated supervision under statutory or regulatory schemes 

that were far less comprehensive than that applicable to bank holding companies. In addition, an 

unregulated shadow banking system (including, for example, unregulated mortgage brokers, 

structured investment vehicles, other asset-backed commercial paper conduits, and securities 

lenders) had emerged that generated mortgages for distribution, funded highly rated senior 

tranches of securitizations, and engaged in maturity transformation and other financial activities 

outside the view of any federal supervisor. 

The system for regulating bank holding companies was, in important ways, inadequate as well. 

One issue of concern was that the Federal Reserve’s consolidated supervision of such companies 

was, by statute, both narrowly focused on the safety and soundness of their bank subsidiaries and 

heavily reliant on functional supervisors of the bank and regulated nonbank subsidiaries of these 

companies; in turn, the functional supervisors themselves were statutorily focused only on the 

safety and soundness of the specific entities they regulated. None of the federal regulators had 

sufficient authority to focus on the systemic risk that large banking organizations posed. 

While it is clear that the framework for financial supervision must address macroprudential risks, 

the Federal Reserve cannot and should not be responsible for oversight of the financial system as 

a whole; no agency has the breadth of expertise and information needed to survey the entire 

system. However, by virtue of the combination of experience and expertise it has developed as 

consolidated supervisor of bank holding companies and state member banks and as a central 

bank, the Federal Reserve is well suited to contribute significantly to an overall scheme of 

systemic regulation, particularly in the areas of consolidated supervision and macroprudential 

supervision. 

It is especially important that consolidated supervision address both safety-and-soundness risks 

at individual institutions and macroprudential risks. Addressing safety-and-soundness risks 

requires the traditional skills of bank supervisors, including expertise in examinations and offsite surveillance of complex banking organizations. The Federal Reserve has acquired and 

maintained that expertise as the primary supervisor of banks of all sizes, including community 
banks, regional banks, and large banks that are state-chartered member banks, as the 

consolidated supervisor of all U.S. bank holding companies, and as the supervisor of the U.S. 

operations of globally active foreign banks. With many nonbank financial firms having 

reorganized as bank holding companies during the crisis, the Federal Reserve already is quite 

familiar with the risk profiles of the vast majority of the large interconnected financial firms. 

Beyond traditional bank examination expertise, however, macroprudential supervision will 

require economic sophistication, including knowledge of the macroeconomic environment, as 

well as substantial expertise regarding money markets, capital markets, foreign exchange 

markets, and other financial markets. Expertise in these areas is essential for developing stress 

scenarios and identifying and addressing vulnerabilities to, and posed by, capital and other 

markets. The Federal Reserve has developed this expertise in the context of macroeconomic 

forecasting and monetary policymaking. Market knowledge is acquired through daily 

participation in financial markets to implement monetary policy and to execute financial 

transactions on behalf of the U.S. Treasury and foreign governments and central banks. 

Macroprudential supervision also requires extensive knowledge of payment and settlement 

systems to understand the interconnections between financial institutions and markets. The 

Federal Reserve has developed this expertise through its operation of some of the world’s largest 

payment and settlement systems (the Fedwire funds and securities transfer systems), its 

supervision of key providers of payment and settlement systems (the Depository Trust Company, 

the CLS Bank, and the government securities clearing banks), and its long-standing leadership 

role in the international Committee on Payment and Settlement Systems. 

The Supervisory Capital Assessment Program, or SCAP, also known as the stress test, was 

critical to restoring confidence in the banking system and was a watershed event for modern 

macroprudential supervision. The Federal Reserve, which took the lead on the SCAP, drew on 

its macroeconomic and markets expertise to model potential credit losses and revenues at the 

SCAP banks. These analyses were essential to assess the amount of capital the SCAP banks 

would need to absorb potential losses and continue to meet the needs of creditworthy borrowers 

in a more adverse economic scenario. In the future, macroprudential supervision should feature 

both increased use of cross-firm, horizontal exams to assess common exposures and 

vulnerabilities as well as forward-looking stress testing based on alternative projections for the 

macroeconomy. 

The Benefits of the Federal Reserve’s Supervisory Role for Its Other Central Banking 

Functions 

The Federal Reserve’s central banking functions significantly enhance its ability to conduct its 

supervisory role, and offer considerable benefits for macroprudential supervision going forward. 

In addition, the complementarity between narrow central banking activities and supervision 

creates advantages in the other direction. The Federal Reserve’s involvement in supervising 
banking institutions of a variety of sizes generates information and expertise that significantly 

improve the Federal Reserve’s ability to effectively carry out its central-bank responsibilities and 

that cannot be obtained reliably through other means, such as relying on reports from other 

supervisors. Among the central-bank responsibilities that benefit from the Federal Reserve’s 

supervisory role are crisis management, providing liquidity to depository institutions, and 

monetary policy. Especially since the start of the crisis in the summer of 2007, the information 

and expertise that the Federal Reserve has had as a result of its supervisory activities have been 

essential to its successful performance of these responsibilities. 

Crisis Management 

The Federal Reserve’s supervisory authority has been of greatest importance to its management 

of financial crises. In particular, its ability to deal with diverse and hard-to-predict threats to 

financial stability depends critically on the information, expertise, and powers that it has by 

virtue of being both a bank supervisor and a central bank.[see footnote 1 below] 

An example of how the Federal Reserve’s supervisory role contributed to its management of a 

crisis came in the context of the October 19, 1987, stock market crash. During that chaotic 

period, banks began to pull back from lending to major securities firms. However, because of 

increased demand for financing from their customers and the differences in the timing of 

payments to and receipts from the exchanges’ clearing and settlement systems, those securities 

firms needed access to substantial bank credit in order to make payments and settle trades. As a 

result, the availability of bank credit was critical to the functioning of equity and securities 

markets as well as futures and options exchanges. A freezing up of these critical markets would 

have caused a deeper and more disruptive financial crisis, likely involving further declines in 

asset values and, ultimately, tighter credit conditions for households and businesses. To combat 

those risks, the Federal Reserve announced its willingness “to serve as a source of liquidity to 

support the economic and financial system.” Subsequently, Federal Reserve examiners on-site in 

major banking organizations assessed funding pressures and potential credit losses to help 

identify emerging problems. Armed with the resulting knowledge and with the benefit of 

existing supervisory relationships, senior Federal Reserve officials contacted the managements 

of the major banks and urged them to use liquidity from the discount window to provide loans to 

creditworthy securities firms. Bank credit was provided to securities firms as requested, 

allowing those firms in turn to make required payments to counterparties and clearing houses. 

[footnote 1] In addition to the examples discussed here, the Federal Reserve has taken steps to address strains at financial 

institutions and in financial markets on a number of other occasions in recent decades, including following the 

bankruptcy of the Penn Central Railroad in 1970, the collapse of a speculative boom in the silver market in 1980, the 

failure of Continental Illinois in 1985, and the global financial strains that followed the Russian default and the 

collapse of Long-Term Capital Management in 1998. See Andrew F. Brimmer (1989). “Distinguished Lecture on 

Economics in Government: Central Banking and Systemic Risks in Capital Markets,” Journal of Economic 

Perspectives, vol. 3 (Spring), pp. 3-16; and Ben S. Bernanke (2007), “Central Banking and Bank Supervision in the 

United States,” speech delivered at the Allied Social Science Association Annual Meeting, Chicago, Ill., January 5, 

www.federalreserve.gov/newsevents/speech/bernanke20070105a.htm. [end footnote 1] 
These actions allowed systemically critical stock, futures, and options exchanges to function 

normally, averting a more prolonged and deeper market crisis with its attendant adverse 

implications for the broader economy. 

A similar example emerged in the case of the failure of Drexel Burnham Lambert in February 

1990. Drexel’s rapid collapse posed a risk of gridlock in the financial markets. Notably, 

because of their parent’s failure, Drexel’s solvent broker-dealer and government securities dealer 

subsidiaries experienced serious difficulties liquidating their positions. Because of its ongoing 

supervisory relationships with the banks that provided settlement services to Drexel’s 

subsidiaries and its knowledge of the payment and settlement system’s infrastructure, the Federal 

Reserve had the access, contacts, and in-depth knowledge that enabled it to obtain the 

information it needed to evaluate this complex problem and formulate a plan to address it. The 

Federal Reserve understood the potential problems of Drexel’s counterparties and clearing banks 

and was able to work with the banks and securities firms to identify developing problems and 

fashion procedures that enabled an orderly winding down of Drexel without adverse effects on 

other market participants or further disruption to financial markets. 

In the aftermath of the September 11, 2001, terrorist attacks, supervisory information and 

supervisory powers to compel the provision of information allowed the Federal Reserve to 

understand the damage incurred by, and estimate the recovery time for, a large banking 

institution that played a major role in key financial markets. Following the attacks, Federal 

Reserve examiners were sent to the institution’s contingency site. This on-site supervisory 

presence proved crucial in helping to obtain necessary information and clarify conflicting 

information in a highly confused and uncertain situation. Similarly, on-site Federal Reserve 

examiners at other key institutions proved to be valuable sources of information about the 

difficulties those institutions were facing. With this information in hand, senior Federal Reserve 

policymakers took the lead in assessing the damage to specific financial institutions and the 

implications for the government securities market and in taking remedial actions--including the 

provision of liquidity by the Federal Reserve--to restore financial market functioning relatively 

quickly. The ability of the Federal Reserve to respond promptly and effectively mitigated the 

adverse effects on broader financial conditions and the national economy of those tragic events. 

During the current crisis, the Federal Reserve’s supervisory role has not only given it timely 

access to information about the banking sector, payments systems, and capital markets, but also 

has been essential to its understanding of the emerging strains on financial firms and their 

possible implications for financial markets and the broader economy. This information has been 

critical to the Federal Reserve’s efforts to identify the difficulties facing depository institutions 

of all sizes and to take steps to address those problems. In particular, over the course of the 

crisis, the Federal Reserve has used supervisory information to monitor the liquidity needs of 

banking organizations in response to the disruptions in a range of short-term funding markets and 

mounting market pressures on firms perceived to be in a weak financial condition. This 

information allowed the Federal Reserve to take steps to address pressing liquidity needs with 
monetary policy and lending programs, thereby avoiding larger dislocations in financial markets 

and an even greater deterioration in economic conditions--which the Federal Reserve continues 

to monitor. 

The Federal Reserve’s supervisory information also contributed importantly to the design of a 

number of Federal Reserve credit programs. In particular, the development of the Primary 

Dealer Credit Facility was greatly aided by the understanding of the triparty repurchase 

agreement (repo) market and the information regarding its functioning that the Federal Reserve 

had as a result of its supervision of the banking organizations that handle the clearing and 

settlement of such transactions. In addition, its understanding of the workings of the credit 

markets along with its involvement in the supervision of banking institutions helped motivate the 

Federal Reserve’s decision to implement the Term Asset-Backed Securities Loan Facility, which 

is a broad-based facility that provides liquidity to support auto lending, small business lending, 

credit card lending, student loans, and commercial real estate lending. The Federal Reserve’s 

credit programs provided significant support to key financial institutions and markets, easing the 

impact of the financial crisis on the economy. 

Liquidity Provision to Depository Institutions 

Supervisory information and expertise also contribute to the Federal Reserve’s management of 

the risks that it confronts in its role as liquidity provider to depository institutions, large and 

small--a critical central-bank function. Reserve Banks must be able to assess the financial 

condition of the institutions that want to borrow from the Federal Reserve and must be able to 

assess as well the quality and value of the collateral pledged by borrowing institutions. Active 

involvement in supervising financial institutions contributes significantly to such assessments 

because they require substantial knowledge of banking practices as well as the expertise gained 

from the hands-on review of loans and other assets at banking organizations. In addition, the 

Federal Reserve’s assessment of the condition of an institution or the quality of its collateral may 

differ from that of other supervisory agencies. 

Monetary Policy 

The information that the Federal Reserve obtains in its supervisory role has been useful for the 

making of monetary policy, especially in periods of financial stress. For example, in the early 

1990s, the Federal Reserve recognized that elevated loan losses were putting pressure on bank 

balance sheets, thereby contributing to very weak bank lending that was weighing on spending 

by households and businesses. In this context, mounting evidence of tightened lending standards 

and credit concerns at banks, much of it gained through the supervisory process, contributed to 

the Federal Reserve’s decision to ease the stance of monetary policy more aggressively than it 

otherwise would have. 

Supervisory information has played a particularly important role in monetary policymaking since 

the outbreak of the financial crisis in the summer of 2007. As the crisis intensified, supervisory 
information helped the policymaking Federal Open Market Committee (FOMC) to understand 

the extent of the dislocations in credit markets and led the Federal Reserve’s monetary policy 

response to the crisis to be more timely and decisive than it otherwise might have been. For 

example, Federal Reserve staff calculated estimates of potential aggregate credit losses under 

alternative economic scenarios and drew on supervisory information and expertise to evaluate 

implications for the health of the banking system. This work helped the FOMC to assess the 

risks to the financial system and the economy arising from worsening credit conditions and to 

take such risks into account in its policy decisions. 

More broadly, information and expertise obtained as a result of the Federal Reserve’s 

supervisory role have been reflected in FOMC meeting discussions of economic conditions and 

the outlook. Supervisory staff has attended these meetings during the crisis, and in these 

discussions there have been regular references to information about banking institutions gained 

both from examination staff and from industry contacts resulting from the Federal Reserve’s 

supervisory role. This information has contributed to the Committee’s understanding of likely 

loan losses, the effects of such losses and other factors on bank lending behavior, and their 

implications for economic activity. Moreover, given the global nature of the financial crisis, the 

Federal Reserve’s interactions with supervisors abroad, which reflect its role as a U.S. 

supervisor, have provided helpful information on the health of key foreign banking firms, 

allowing the FOMC to judge more accurately the likely strains on U.S. financial firms and 

markets emanating from outside the United States. 

The Federal Reserve faces challenging decisions regarding the timing and pace of the exit from 

the considerable monetary accommodation put in place during the crisis. These critical policy 

decisions will require particularly careful assessments of developments at financial institutions 

and in financial markets, and their resulting implications for the real economy. For example, 

losses on commercial real estate loans may continue to undermine some community and regional 

banks and will have uneven effects across different regions of the country. At the same time, 

however, the improving economy may strengthen the balance sheets of other banks and 

conditions in many financial markets may continue to improve. Information from the 

supervisory process will help policymakers to assess overall credit conditions and the stability of 

the financial sector, and so to time appropriately the shift to reduced policy accommodation. 

Could the Federal Reserve Obtain What It Needs from Another Supervisor? 

A natural question is whether the Federal Reserve could obtain the supervisory information and 

expertise it needs for its central-bank responsibilities from other agencies. While it seems clear 

that this is possible to some extent--indeed, the Federal Reserve obtains information regarding 

the firms to which it lends from their primary supervisors--elimination of the Federal Reserve’s 

role in supervision would severely undermine the Federal Reserve’s ability to obtain in a timely 

way and to evaluate the information it needs to conduct its central banking functions effectively. 
First, active involvement in supervision ensures that the Federal Reserve will have experts on its 

staff with significant knowledge of banking practices and financial instruments gained from the 

hands-on review of banking organizations and their operations, practices, activities and balance 

sheets. This expertise is critical to making effective use of information about financial firms and 

cannot be quickly created when needed. For example, without staff expertise in bank lending 

practices and evaluating bank asset quality, the Federal Reserve would be unable to assess 

independently and rapidly the condition of borrowing institutions and the value of the collateral 

they pledge at the discount window. This capability has been especially valuable since the 

Federal Reserve began providing credit at longer maturities during the crisis. Indeed, in some 

cases, it has been necessary for the Federal Reserve to deploy supervisory experts to provide upto-date assessments of the condition of borrowing firms and to evaluate the collateral they were 

providing. Owing in part to the supervisory expertise it has been able to bring to bear in its 

discount window operations, the Federal Reserve has maintained its record of never bearing a 

loss on credit it has extended to depository institutions, despite the spike in such lending to more 

than $500 billion in early 2009. 

Second, obtaining information from another agency would be slower and more cumbersome than 

obtaining it directly from financial firms. Information provided by other supervisory agencies 

may be stale or incomplete, particularly in a crisis, when the condition of institutions and the 

value of collateral can deteriorate rapidly. An independent supervisor would have its own 

concerns and priorities on which its supervisory staff would naturally focus, slowing the Federal 

Reserve’s access to information in other areas. Even if the supervisory agency’s staff were 

willing and able to provide assistance, the back-and-forth process in which the Federal Reserve 

must explain exactly what is needed, evaluate the information that is received, and return to the 

supervisor with clarifying questions and requests for additional information could slow the 

process appreciably. 

Finally, having the legal authority to directly obtain information--through on-site examinations 

or otherwise--can prove critical to understanding and responding quickly to a financial crisis. 

While in some cases financial institutions that the Federal Reserve does not supervise may be 

willing to provide information to the Federal Reserve on a voluntary basis, in other cases they 

have not been willing, and there is no guarantee that they will be willing in future crises. For 

example, senior managers with relevant knowledge about the nature of the problems facing an 

institution or arising in financial markets may well be focused on those problems and therefore 

might not want to meet with, or provide information to, the Federal Reserve in a timely manner 

unless the Federal Reserve had the supervisory authority to require them to do so. Also, an 

institution may not readily recognize or acknowledge the possible adverse effects of its actions 

for other market participants or the financial markets and economy more generally, or it may 

expect the authorities to deal with such adverse effects. In such cases, it can be essential for the 

Federal Reserve to have the ability to compel the disrupted institution to provide timely 
information that would assist the Federal Reserve in addressing the crisis through its monetary 

policy, lending, and other policy and operational tools. 

Besides the experience at the Federal Reserve, international developments suggest that a centralbank role in supervision can be important. For example, many have suggested that the problems 

with Northern Rock in the United Kingdom were compounded by a lack of clarity regarding the 

distribution of powers, responsibilities, and information among the Bank of England, the U.K. 

Financial Services Authority, and the U.K. Treasury. In response, the Bank of England was 

given statutory responsibilities in the area of financial stability, its powers to collect information 

from banks were augmented, and many have called for it to be given increased supervisory 

authority. In the European Union, a new European Systemic Risk Board is being established 

under which national central banks and the European Central Bank will play a central role in 

efforts to protect the financial system from systemic risk. More broadly, in most industrial 

countries today the central bank has substantial bank supervisory authorities, is responsible for 

broad financial stability, or both. 

Steps the Federal Reserve Is Taking to Strengthen its Regulatory and Supervisory 

Performance 

Supervision by financial regulators, including the Federal Reserve, clearly had significant 

shortcomings in the period leading up to the financial crisis. Among other things, regulators did 

not insist on sufficiently strong and comprehensive risk management by private firms, and 

inadequate attention was paid to the risks that could arise from the interactions of firms and 

markets, such as the collective dependence of many firms on similar wholesale funding sources 

or hedging strategies. The Federal Reserve has been and continues to be engaged in an intensive 

self-examination of its supervisory functions with two objectives: to address weaknesses in its 

supervisory function that became apparent as a result of the financial crisis, and to become a 

better supervisor in an environment that requires supervisors to be attentive to macroprudential 

as well as individual-institution safety-and-soundness risks. 

The Federal Reserve is seriously engaged in measures to strengthen its regulatory and 

supervisory performance. For example, working through the Basel Committee on Bank 

Supervision and the Financial Stability Board, the Federal Reserve has played a key part in 

efforts to ensure that systemically critical financial institutions hold more and higher-quality 

capital and employ more robust liquidity management. The Federal Reserve also played a key 

role in international work to ensure that banks use compensation structures that provide 

appropriate performance and risk-taking incentives. Domestically, it has taken the lead in 

addressing flawed compensation practices, issuing proposed guidance that would require 

banking organizations to review their compensation practices to ensure that they do not 

encourage excessive risk-taking, are subject to effective controls and risk management, and are 

supported by strong corporate governance, including oversight by their boards of directors. 
In the fall of 2008, the Federal Reserve updated its guidance on consolidated supervision, 

reaffirming the importance of such supervision, particularly for large complex firms, and 

emphasizing the importance of bringing a macroprudential perspective as well as an individualinstitution safety-and-soundness perspective to consolidated supervision. Of considerable 

importance, the Federal Reserve has taken steps to ensure that, when risk-management 

shortcomings are identified, its supervisors hold managers accountable and make sure that 

weaknesses receive proper attention at senior levels and are resolved promptly. This requires 

routinely and promptly communicating important supervisory concerns to the highest levels of 

bank management, including through more frequent involvement of senior bank managers and 

boards of directors and senior Federal Reserve officials. This approach proved especially 

effective during the SCAP and in other circumstances when clear expectations for prompt 

remediation were forcefully communicated to large banking organizations. 

The Federal Reserve has also begun to make fundamental changes to its supervision and 

regulation of large bank holding companies to include a macroprudential, as well as an 

individual-institution safety-and-soundness, perspective to supervision. For example, the Federal 

Reserve is developing a program of enhanced quantitative surveillance of large bank holding 

companies. Enhanced quantitative surveillance combines aggregate economic data, firm-level 

market-based indicators, and supervisory information to provide a fuller picture of the financial 

condition of firms, the risks they face, and their potential effects on the broader system. 

Examples of this approach are the indicative systemwide loss and pre-provision net revenue 

estimates that were developed for the SCAP and used in the subsequent analysis of Troubled 

Asset Relief Program redemption requests, and the firm-specific loss and revenue estimates that 

were developed by combining these systemwide estimates with supervisory information. 

The Federal Reserve is working with other domestic and international regulators and market 

participants to overcome the collective action problems that often plague efforts to strengthen 

market infrastructure. Since 2005, the Federal Reserve has been leading efforts by market 

participants and domestic and international regulators to strengthen the infrastructure of the 

credit derivatives and other over-the-counter derivatives markets. While further progress is 

needed, without the progress that was achieved since 2005, the failures of major dealers and 

defaults by some of the very largest names traded in the credit derivatives markets surely would 

have been far more disruptive than they were. Likewise, this year the Federal Reserve took the 

lead in organizing a private-sector group that is developing recommendations for cooperative 

measures to strengthen margin and settlement practices in the triparty repo markets. 

The Federal Reserve is also making changes designed to fully employ its expertise to effectively 

supervise large banking firms. The new supervisory framework will better accommodate a 

macroprudential orientation that goes beyond the traditional focus on individual institutions and 

better supports the identification and analysis of interconnected risks and sources of financial 

contagion. The new approach will implement a more centralized approach to the supervision of 

large, complex banks that are potentially systemically important. 
In particular, strategic and policy direction for the supervision of large, complex financial 

institutions will be coordinated through a newly formed multidisciplinary committee led by 

senior officers representing various functions at the Board and Reserve Banks. Supervisors, 

economists, and market specialists, combined with officials responsible for quantitative 

surveillance activities, will define supervisory priorities and examination plans for large, 

complex banking organizations. Supervisory teams will be constructed around portfolios of 

firms with similar business lines and risks, and cross-firm examinations will consider 

interconnected risks, such as spillover and feedback effects. 

As in the SCAP, representatives of primary and functional supervisors will be fully integrated in 

the process, participating in the planning and execution of horizontal exams and consolidated 

supervisory activities. As was evident in the recent crisis, interconnected risks can span several 

operating entities. Subprime mortgage exposures, for example, were dispersed across mortgage 

banks, broker-dealers, and off-balance-sheet vehicles, as well as insured depositories. Effective 

supervision of complex holding company structures must involve greater coordination among 

consolidated and functional supervisors and an integrated assessment of risks across the holding 

company, including bank and nonbank subsidiaries. 

While supervisory authorities here and abroad are still developing the tools and instruments 

needed to fully implement a macroprudential approach to supervision, recent experience has 

shown that such an approach is critical to avoiding financial imbalances that can result in severe 

financial and economic dislocations. The Federal Reserve will continue to strengthen its 

supervisory efforts and to learn from events as they unfold, with the goal of doing all in its power 

to identify and address risks that may imperil the financial system.