Second, we could impose higher capital requirements on large, systemically important institutions to offset the advantages such as lower funding costs that these institutions may garner by their perceived “too big to fail” status. This would recognize the interconnectedness of the financial system and the fact that the failure of a systemically important institution generates significant externalities, which are not, at present, borne fully by the equity and debt holders of such institutions. Increasing the size of the capital buffer would make the system more stable by reducing the incentive for firms to get big just to capture the perceived benefits from achieving “too big to fail” status. The first change – an improved resolution mechanism – would presumably reduce the number of institutions that – at any point in time – would be systemically important. The second change – the imposition of higher capital requirements on large, systemically important institutions – would reduce the likelihood of failure of such institutions. However, in assessing the efficacy of such changes, we need to be realistic about the difficulties in building a resolution regime that would be sufficiently robust to allow the failure of any institution under any circumstance and in designing a capital regime that imposes  BIS Review 125/2009  5  differential requirements on large, systemically important institutions. On the resolution regime side of the ledger, it is particularly difficult to build resolution regimes that can operate effectively across different geographic jurisdictions.

The inadequate level of transparency and disclosure, particularly in the market for structured products, were also important in making the financial system more fragile and vulnerable to crisis and in increasing the degree of uncertainty and contagion once the crisis was underway. Only by fully understanding these shortcomings can we construct solutions that will strengthen our financial system and make it more robust. The initiatives underway to strengthen our financial system span a wide range of supervisory and regulatory policy areas, including ongoing efforts to improve standards for both the capital and liquidity held by financial institutions, efforts to improve the risk management practices at financial institutions and efforts to strengthen the resiliency of market infrastructures. Today, I am going to focus mainly on the need to improve the capital standards for large, systemically important financial institutions. For initiatives in this area to be effective, we need to make progress on three distinct, but related fronts: •  a more thorough and complete risk capture so that the capital adequacy rules more effectively encompass a broader set of risk exposures than before,  •  rules that encourage the conservation of capital in adverse economic and financial circumstances, and  •  tougher regulatory requirements, including the use of a contingent capital instrument that would automatically replenish equity capital in times of stress. As always, my remarks reflect my own views and opinions and not necessarily those of the Federal Open Market Committee or the Federal Reserve System.