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.

If we in the United States and other deficit countries are to move to a more healthy balance of private and public spending in relation to income, other countries cannot be as reliant on us as in the past to be their growth engine. The recent configuration of global demand, after all, has involved persistent trade surpluses in many emerging markets and this represents foregone consumption and investment that has mostly been recycled into large scale accumulation of foreign exchange reserves. To be sure, the crisis demonstrated the value of an ample reserve cushion to protect against sharp shifts in capital flows. However, a number of countries have surely reached a point at which further reserve accumulation comes with more costs than benefits. The expected return on foreign exchange reserves is likely to be quite low in relation to potential domestic uses. In fact, there is the prospect that reserves could earn a significantly negative return in local currency terms, especially when the acquisition of such reserves is undertaken to resist local currency appreciation that must eventually occur anyway. Finally, delay in adjustment of demand patterns and currencies raises the risk that these adjustments will ultimately occur in a more compressed and wrenching manner. How many times have we seen bottled-up pressures ultimately give way to disruptive overshooting? Moreover, lack of progress on rebalancing demand would put at risk the open trading regime that has been so important to global prosperity and growth. To date, protectionist pressures have been largely contained.