volatility in financial markets. this prospect makes this a good time to examine the health of the financial system. the strength of the financial system is a major factor in determining how well economies respond to shocks - weak financial systems amplify the damage to growth. the stronger the financial system, the more effective policy - monetary policy in particular - can be in cushioning the effects of those shocks and helping to restore expansion. we are fortunate in the united states today to have a strong financial system. this system has a tremendous capacity to match capital to ideas, reward innovation, and channel savings to the highest return. and it has demonstrated a capacity for very considerable resilience and stability in face of shocks. what are the main sources of these strengths? our banks are stronger than they have been in the past. their larger earnings capacity, higher capital cushions, and the greater diversity of their activities help shield them from a broader range and greater magnitude of shocks than in the past. capital markets play a comparatively larger role in our financial system. as a consequence, shocks get diffused more broadly, and weakness in traditional intermediation channels can be offset by the strength in other channels. here in the united states, financial innovation has advanced farther and more rapidly than elsewhere. this reflects a regulatory model that is more supportive of competition, of financial innovation, and of market - driven improvements in risk management. the u. s. financial system has embraced opportunities for risk transfer much more rapidly and extensively than other systems. finally, we have larger and more developed venture capital, private equity, and hedge fund segments within our financial system. these are important sources of liquidity, they add depth and breadth to capital markets, and they play a valuable arbitrage role in reducing or eliminating mispricing in the financial markets. however, no system is invulnerable to stress and crisis. recent u. s. financial history is not a history of the uninterrupted achievement of ever higher returns. the stock market crash of ’ 87, the stress that surrounded the russian default and the collapse of long term capital management, and the more recent fall in equity prices that came with the collapse of the technology boom all posed significant potential threats to financial stability. in each case, however, with a swift monetary policy response and other actions the process of recovery and repair was reasonably quick. the relative ease with which we managed through these events has reinforced confidence in the stability of the system. this confidence is

, short - term interest rates at the zero lower bound, and the economy far away from our dual mandate objectives. now that these circumstances no longer hold, it seems appropriate to begin to reduce the size of the fed ’ s balance sheet. in thinking about the decision to reduce the size of the fed ’ s balance sheet, i see two important, opposing factors. one is that a large balance sheet could conceivably make further asset purchases less attractive. this factor suggests that we should use the opportunity to shrink the balance sheet during good economic times so that this tool will be fully available to us in the 4 / 6 bis central bankers'speeches future if necessary. however, on the other side, reducing the size of the balance sheet is another form of monetary tightening, one with which we have little experience. this suggests we should proceed with caution. the fomc has judged that a gradual, predictable approach to normalization is the best way to appropriately balance these two factors. another question is how long the normalization process will take. assuming that this process begins later this year and continues uninterrupted, the balance sheet size would likely normalize in the early part of the next decade. 4 there is uncertainty about the exact timing for several reasons. we don ’ t know how fast our agency mbs holdings will pre - pay, how quickly currency outstanding will grow, how many bank reserves will be required for the efficient execution of monetary policy, or the evolution of other liability items on the fed ’ s balance sheet that affect the amount of bank reserves. against that backdrop, one major issue that remains outstanding is whether the fed will continue to operate with a “ floor ” system, in which the fed maintains a relatively abundant supply of reserves and the effective federal funds rate is managed by periodic adjustments to the interest rate the fed pays on bank reserves. or, whether the fed will move back to a “ corridor ” system, in which reserves are relatively scarce and the effective federal funds rate is managed by frequently adjusting the supply of reserves to meet demand at the desired federal funds rate level. in this type of regime, it is the quantity of reserves, rather than the interest rate the fed pays on reserves, that is the primary driver of the federal funds rate. 5 having managed the system open market account during the financial crisis — a period during which the demand for reserves was very volatile — i very much favor a floor - type system. it is much easier to manage on a day -