Asymmetric information also creates issues on the liability side of a bank’s balance sheet. The banks’ creditors – depositors or providers of funding – don’t have as much information about the health of the institution as insiders do. This asymmetry makes banks opaque and inherently fragile, which can subject them to runs. This type of “run risk” has been largely mitigated, at least in the case of retail depositors, by deposit insurance, access to lender of last resort facilities, and other elements of the bank safety net. Importantly, however, a broad safety net weakens market discipline of banks and can create incentives for excessive risk-taking. This contributes to the need for risk-sensitive regulation and supervision. Regulations can control risk-taking through a variety of means such as setting minimum requirements for capital and liquidity positions, while supervision can identify and constrain activities that are not well-captured through regulation but still affect a firm’s risk management, governance and control infrastructure. One common objective is to counter the incentive for excessive risk-taking by intermediaries. •  Externalities A second and distinct type of market failure that creates a need for public sector intervention stems from the externalities that the failure of a large, systemically important bank failure can have on the rest of the financial sector or the economy as whole. For example, the financial crisis vividly demonstrated how the distress of a large financial firm can destabilize broader financial markets and impact other financial firms. These effects can be seen through direct linkages via counterparty exposures.

Our staff assesses the safety and soundness of domestic banking institutions and operations of foreign banking organizations in the district through onsite evaluations and offsite financial analysis and surveillance. One of our fundamental responsibilities is to ensure that each institution has in place the appropriate risk identification and risk management processes that are necessary for prudent banking. We also analyze issues and industry developments to identify emerging risks and to contribute to the development of domestic and international supervisory policy. I’ll return to a discussion of emerging risks later in my talk. BIS central bankers’ speeches  1  The Supervision Group at the New York Fed works with our colleagues around the Federal Reserve System to develop and implement the System’s supervisory programs. This includes working through governance structures like the Large Institution Supervision Coordinating Committee (LISCC) that oversees supervision for the largest, most systemically important institutions in the U.S. We are also involved in similar System-wide committees for other types of institutions such as community banks, regional banks, foreign banks, and other large banking institutions, as well as consumer protection. I’ll speak mostly today about our supervisory responsibilities for the largest firms, but will note that we recently hosted a conference at the New York Fed focusing on the role of community banks. For the largest firms, we actively participate in System-wide horizontal examinations such as the Comprehensive Capital Analysis and Review, or CCAR, which is the annual process for evaluating capital adequacy of the largest firms that began last week.