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A Conversation with Ben S. Bernanke

Speaker: Ben S. Bernanke, Chairman, Federal Reserve
Presider: David M. Rubenstein, Co-Founder, The Carlyle Group
March 10, 2009

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DAVID M. RUBENSTEIN:  I'd like to welcome everybody today to the Council on Foreign Relations meeting.  This meeting is part of the C. Peter McColough Series on International Economics.    

We have a full house here today.  For those who are listening in outside this room -- we have several hundred members of the council around the country who are listening in.  And for those who are listening in, we have a full house here in our headquarters in Washington.  

I'd like to ask everybody now to turn off your cell phones, your BlackBerrys, your wireless devices, no vibrations, no anything, if you can.  I hope you can do that.  And we're ready to start.  

I'm David Rubenstein, a member of the Council on Foreign Relations board.  And on behalf of the council, I'm very pleased that we have the chairman of the Federal Reserve here today to make some remarks.  I will just give you a very brief introduction, since he obviously needs very little introduction.  

The chairman has been the chairman for about three years.  And in that period of time, he has had to face some of the most difficult economic and fiscal policy decisions and monetary police decisions of any chairman of the Federal Reserve.  Indeed, in this short period of time, I doubt if any other chairman of the Federal Reserve has had to deal with as many complicated and historic issues as this chairman has had.  

He was well prepared for this, though.  Probably nobody has become chairman with as deep a grounding in what the Federal Reserve does as this chairman.  He served as a professor at Princeton for many years and chairman of the department of economics for many years as well and in that capacity wrote four textbooks on macro- and microeconomics, wrote more than 30 scholarly articles and was an expert on the Federal Reserve and particularly the way it handled the Great Depression.  Prior to going to Princeton, he had taught at NYU and at Stanford Business School.  

Prior to becoming the chairman of the Federal Reserve, he was asked by President Bush to serve as a member of the Federal Reserve and served for three years prior to going to the White House to serve as the chairman of the Council of Economic Advisers.  

The chairman of the Federal Reserve comes from very modest circumstances, from Dillon, South Carolina, where he was a child prodigy as well, and was well recognized then for his intellectual skills.  He grew up as the valedictorian of his high school class, near-perfect scores on SATs -- and was the South Carolina spelling bee champion.  (Laughter.)  

He came to the national tournament, and didn't win.  He failed because he couldn't spell the word "eidelweiss."  And as he told me, that was because there was no movie theater playing "The Sound of Music" in Dillon, South Carolina.  (Laughter.)  

We're very pleased today that the chairman is going to give us some remarks on regulatory reform.  And then after he's finished those remarks, we will have time for questions.  Most of the time will be questions from the audience and those who are listening in from around the country.  

So, Chairman Bernanke.  (Applause.)  

BEN S. BERNANKE:  Thank you very much, David.  And good morning, everybody.  

The world is suffering through the worst financial crisis since the 1930s, a crisis that has precipitated a sharp downturn in the global economy.  Its fundamental causes remain in dispute.  In my view, however, it is impossible to understand the crisis without reference to the global imbalances in trade and capital flows that began in the latter half of the 1990s.  

In simplest terms, these imbalances reflected a chronic lack of saving relative to investments in the United States and some other industrial countries, combined with an extraordinary increase in saving relative to investment in many emerging market nations.  The increase in excess saving in the emerging world resulted in turn from factors such as rapid economic growth in high-saving East Asian economies, accompanied outside of China by reduced investment rates; large buildups in foreign exchange reserves in a number of emerging markets; and substantial increases in revenues received by exporters of oil and other commodities.  

Like water seeking its level, saving flowed from where it was abundant to where it was deficient, with the result that the United States and some other advanced countries experienced large capital  inflows for more than a decade, even as real long-term interest rates remained low.  

The global imbalances were the joint responsibility of the United States and our trading partners, and although the topic was a perennial one at international conferences, we collectively did not do enough to reduce those imbalances.  However, the responsibility to use the resulting capital inflows effectively fell primarily on the receiving countries, particularly the United States.  

The details of this story are complex, but broadly speaking, the risk management systems of the private sector and government oversight of the financial sector in the United States and some other industrial countries failed to ensure that the in-rush of capital was prudently invested, a failure that has led to a powerful reversal in investor sentiment and a seizing-up of credit markets.  

In certain respects, our experience parallels that of some emerging market countries in the 1990s whose financial sectors and regulatory regimes likewise proved inadequate for efficiently investing large inflows of saving from abroad.  When those failures became evident, investors lost confidence and crises ensued.  A clear and highly consequential difference, however, is that the crises of the 1990s were regional, whereas the current crisis has become global.  

In the near term, governments around the world must continue to take forceful and, when appropriate, coordinated actions to restore financial market functioning and the flow of credit.  I have spoken on a number of occasions about the steps that the U.S. government, especially the Federal Reserve, is taking along these lines.  Until we stabilize the financial system, a sustainable economic recovery will remain out of reach.    

In particular, the continued viability of systemically important financial institutions is vital to that effort.  In that regard, the Federal Reserve, other federal regulators, and the Treasury Department have stated that they will take any necessary and appropriate steps to ensure that our banking institutions have the capital and liquidity necessary to function well, even in a severe economic downturn. Moreover, we have reiterated the U.S. government's determination to ensure that systemically important financial institutions continue to be able to meet their commitments.  

At the same time that we are addressing such immediate challenges, it is not too soon for policymakers to begin thinking about the reforms to the financial architecture, broadly conceived, that could help prevent similar crises from developing in the future. We must have a strategy that regulates the financial system as a whole, in a holistic way, not just at its individual components.  In particular, strong and effective regulation and supervision of banking institutions, although necessary for reducing systemic risk, are not sufficient by themselves to achieve this aim.  

Today, I would like to talk about four key elements of such a strategy.  First, we must address the problem of financial institutions that are deemed too big, or perhaps too interconnected, to fail.    

Second, we must strengthen what I will call the financial infrastructure -- the systems, rules, and conventions that govern trading, payment, clearing and settlement in financial markets -- to ensure that it will perform well under stress.    

Third, we should review regulatory policies and accounting rules to ensure that they do not induce excessive pro-cyclicality, that is, they do not overly magnify the ups and downs in the financial system and in the economy.   

And finally, we should consider whether the creation of an authority specifically charged with monitoring and addressing systemic  risks would help protect the system from financial crises like the one we are currently experiencing.    

My discussion today will focus on the principles that should guide regulatory reform, leaving aside important questions concerning how the current regulatory structure might be reworked to reduce balkanization and overlap and increase effectiveness.  I will also not say much about the international dimensions of the issue, but I will take as self-evident that, in light of the global nature of financial institutions and markets, the reform of financial regulation and supervision should be coordinated internationally to the greatest extent possible.  

In a crisis, the authorities have strong incentives to prevent the failure of a large, highly interconnected financial firm because of the risks that such a failure would pose to the financial system and to the broader economy.   

However, the belief of market participants that a particular firm is considered too big to fail has many undesirable side effects.  For instance, it reduces market discipline and encourages excessive risk- taking by the firm.  It also provides an artificial incentive for firms to grow in order to be perceived as too big to fail.  And it creates an un-level playing field with smaller firms, which may not be regarded as having implicit government support.  Moreover, government rescues of too-big-to-fail firms can be costly to taxpayers, as we have seen recently.  Indeed, in the present crisis the too-big-to-fail issue has emerged as an enormous problem.  

In the midst of this crisis, given the highly fragile state of financial markets in the global economy, government assistance to avoid the failures of major financial institutions has been necessary to avoid a further destabilization of the financial system, and our commitment to avoiding such a failure remains firm.  Looking to the future, however, it is imperative that policymakers address this issue by better supervising systemically critical firms to prevent excessive risk-taking and by strengthening the resilience of the financial system to minimize the consequences when a large firm must be unwound.  

Achieving more effective supervision of large and complex financial firms will require a number of actions.  First, supervisors need to move more vigorously -- as we are already doing -- to address the weaknesses at major financial institutions in capital adequacy, liquidity management and risk management, the failures that have been revealed by the crisis.  In particular, policymakers must insist that the large financial firms that they supervise be capable of monitoring and managing their risks in a timely manner and on an enterprise-wide basis.    

In that regard, the Federal Reserve has been looking carefully at risk-management practices at systemically important institutions to identify best practices, assess firms' performance and require improvement where deficiencies are identified.  Any firm whose failure would pose a systemic risk must receive especially close supervisory oversight of its risk-taking, risk management and financial condition, and be held to high capital and liquidity standards.  In light of the global reach and diversified operations of many large financial firms, international supervisors of banks, securities firms and other financial institutions must collaborate and cooperate on these efforts.  

Second, we must ensure a robust framework -- both in law and in practice -- for consolidated supervision of all systemically important  financial firms that are organized as holding companies.  The consolidated supervisors must have clear authority to monitor and address safety and soundness concerns in all parts of the organization, not just the holding company.  Broad-based application of the principle of consolidated supervision would also serve to eliminate gaps in oversight that would otherwise allow risk-taking to migrate from more-regulated to less-regulated sectors.  

Third, looking beyond the current crisis, the United States also needs improved tools to allow the orderly resolution of a systemically important non-bank financial firm, including a mechanism to cover the costs of the resolution.  In most cases, federal bankruptcy laws provide an appropriate framework for the resolution of non-bank financial institutions.  However, this framework does not sufficiently protect the public's strong interest in ensuring the orderly resolution of non-depository financial institutions when a failure would pose substantial systemic risks.  

Improved resolution procedures for these firms would help reduce the Too Big to Fail problem, by narrowing the range of circumstances that might be expected to prompt government intervention, to keep the firm operating.    

Developing appropriate resolution procedures, for potentially systemic financial firms, including bank holding companies, is a complex and challenging task.  Models do exist though, including the process currently in place under the Federal Deposit Insurance Act (FDIA), for dealing with failing insured depository institutions, and the framework established for Fannie Mae and Freddie Mac under the Housing and Economic Recovery Act of 2008.    

Both models allow a government agency to take control of a failing institution's operations and management, act as conservator or receiver for the institution and establish a bridge institution to facilitate an orderly liquidation or sale of the firm.    

The authority to bridge a failing institution, through a receivership to a new entity, reduces the potential for market disruption while limiting moral hazard and mitigating any adverse impact of government intervention on market discipline.    

The new resolution regime must be carefully crafted.  For example, clear guidelines must define which firms could be subject to the alternative regime.  And the process for invoking that regime, analogous perhaps to the procedures for invoking the so-called systemic risk exception, under the FDIA, must be clear.    

In addition, given the global operations of many large and complex financial firms and the complex regulatory structures under which they operate, any new regime must be structured to work as seamlessly as possible with other domestic or foreign insolvency regimes that might apply, to one or more parts of the consolidated organization.    

The first element that I've just described, of my proposed reform agenda, covers systemically important institutions considered individually.  The second element focuses on interactions among firms, as mediated by what I have called the financial infrastructure or the financial plumbing, if you will.  That is the institutions that support trading, payments, clearing and settlement.    

Here, the aim should be not only to help make the financial system as a whole better able to withstand future shocks but also to  mitigate moral hazard and the problem of Too Big to Fail, by reducing the range of circumstances in which systemic stability concerns might prompt government intervention.  Let me give several examples.    

First, since September 2005, the Federal Reserve Bank of New York has been leading a major joint initiative, by the public and private sectors, to improve arrangements for clearing and settling credit default swaps and other over-the-counter derivatives.    

As a result, the accuracy and timeliness of trade information has improved significantly.  However the infrastructure for managing these derivatives is still not as efficient or transparent as that for more mature instruments.    

The Federal Reserve Bank of New York, in conjunction with other federal and domestic supervisors, will continue to work toward establishing increasingly stringent targets and performance standards for market participants.    

To help alleviate counterparty credit concerns, regulators are also encouraging the development of a well-regulated and prudently- managed central clearing counterparty for OTC trades.    

Just last week, we approved the application for membership in the Federal Reserve System of ICE Trust, a trust company that proposes to operate as a central counterparty and clearinghouse for CDS transactions.  

The Federal Reserve and other authorities also are focusing on enhancing the resilience of the triparty repurchase agreement, or triparty repo market, in which the primary dealers and other major banks and broker-dealers obtain very large amounts of secured financing from money market mutual funds and other short-term, risk- averse sources of funding.  For some time, market participants have been working to develop a contingency plan for handling a loss of confidence in either of the two clearing banks that facilitate the settlement of triparty repos.   

Recent experience demonstrates the need for additional measures to enhance the resilience of these markets, particularly as large borrowers have experienced acute stress.  The Federal Reserve's Primary Dealer Credit Facility, launched in the wake of the Bear Stearns collapse and expanded in the aftermath of the Lehman Brothers bankruptcy, has stabilized this crucial market, and market confidence has been maintained.   

However, this program was adopted under our emergency powers to address unusual and exigent circumstances.  Therefore, more-permanent reforms are needed.  For example, it may be worthwhile considering the costs and benefits of a central clearing system for this market, given the magnitude of exposures generated and the vital importance of this market to both dealers and to investors.  

More broadly, both the operational performance of key payment and settlement systems and their ability to manage counterparty and market risks in both normal and stressed environments are critical to the stability of the broader financial system.  Currently, the Federal Reserve relies on a patchwork of authorities, largely derived from our role as a banking supervisor, as well as on moral suasion to help ensure that critical payment and settlement systems have the necessary procedures and controls in place to manage their risks.  By contrast, many major central banks around the world have an explicit statutory basis for the oversight of these systems.  Given how important robust payment and settlement systems are to financial stability, a good case can be made for granting the Federal Reserve explicit oversight authority for systemically important payment and settlement systems.  

Another issue that warrants attention is the potential fragility of the money market mutual fund sector.  Last fall, as a result of losses on Lehman Brothers commercial paper, a prominent money market mutual fund "broke the buck."  That is, it was unable to maintain a net asset value of $1 per share.  Over subsequent days, fearful investors withdrew more than $250 billion from prime money market mutual funds.  The magnitude of these withdrawals decreased only after the Treasury announced a guarantee program for money market mutual fund investors and the Federal Reserve established a new lending program to support liquidity in the asset-backed commercial paper market.  

In light of the importance of money market mutual funds -- and, in particular, the crucial role they play in the commercial paper market, a key source of funding for many businesses -- policymakers should consider how to increase the resiliency of those funds that are susceptible to runs.  

One approach would be to impose tighter restrictions on the instruments in which money market mutual funds can invest, potentially requiring shorter maturities and increased liquidity.  A second approach would be to develop a limited system of insurance for money market mutual funds that seek to maintain a stable net asset value. For either of these approaches or others, it would be important to consider the implications not only for the money market mutual fund industry itself, but also for the distribution of liquidity and risk in the financial system as a whole.  

Third, it seems obvious that regulatory and supervisory policies should not themselves put unjustified pressure on financial institutions or inappropriately inhibit lending during economic downturns.  However, there is some evidence that capital standards, accounting rules and other regulations have made the financial sector excessively procyclical -- that is, they lead financial institutions to ease credit in booms and tighten credit in downturns more than is justified by changes in the creditworthiness of borrowers, and thereby intensifying cyclical changes.  

For example, capital regulations require that banks' capital ratios meet or exceed fixed minimum standards for banks to be considered safe and sound by their regulators.  Because banks typically find raising capital to be difficult in economic downturns or periods of financial distress, their best means of boosting their regulatory capital ratios during difficult periods may be to reduce new lending, perhaps more so than is justified by the credit environment.    

We should review capital regulations to ensure that they are appropriately forward-looking, and that capital is allowed to serve its intended role as a buffer, one that is built up during good times and drawn down during bad times in a manner consistent with safety and soundness.  In the area of prudential supervision, we should also ensure that bank examiners appropriately balance the need for caution and the benefits of maintaining profitable lending relationships when evaluating bank lending policies.  

The ongoing move by those who set accounting standards towards requirements for improved disclosure and greater transparency is a positive development that deserves our full support.  However, determining appropriate valuation methods for illiquid or idiosyncratic assets can be very difficult, to put it mildly. Similarly, there is considerable uncertainty regarding the appropriate levels of loss reserves for loans over the cycle.    

As a result, further review of accounting standards governing valuation and loss provisioning would be useful, and might result in modifications to the accounting rules that reduce their procyclical effects without compromising the goals of disclosure and transparency. Indeed, work is under way on these issues through the Financial Stability Forum, and the results of that work may prove useful for U.S. policymakers.  

Another potential source of procyclicality is the system for funding deposit insurance.  In recognition of this fact, as well as the weak economic outlook and the current strains on banks and the financial system, the Federal Deposit Insurance Corporation recently announced plans to extend from five years to seven years the period over which it would restore the Deposit Insurance Fund to its minimum required level.  This plan, if implemented, should help to reduce the cost imposed on banks at a time when capital and lending are already under pressure.    

Policymakers should consider additional steps to reduce the possible procyclical effects of deposit insurance costs while still ensuring that riskier banks pay higher premiums than safer banks.  One possibility would be to raise the level to which the designated reserve ratio may grow in benign economic environments, so that a larger buffer is available to be drawn down when economic conditions worsen and losses to the insurance fund are high.  

And finally, the policy actions I've discussed would inhibit the buildup of risks within the financial system and improve the resilience of the financial system to adverse shocks.  Financial stability, however, could be further enhanced by a more explicitly macroprudential approach to financial regulation and supervision in the United States.  Macroprudential policies focus on risks to the financial system as a whole.  Such risks may be cross-cutting, affecting a number of firms and markets, or they may be concentrated in a few key areas.  A macroprudential approach would complement and build on the current regulatory and supervisory structure in which the primary focus is the safety and soundness of individual institutions or individual markets.  

How could macroprudential policies be better integrated into the regulatory and supervisory system?  One way would be for the Congress to direct and empower a governmental authority to monitor, assess and, if necessary, address potential systemic risks within the financial system.  The elements of such an authority's mission could include, for example, monitoring large or increasingly rapid -- rapidly increasing exposures, such as to subprime mortgages, across firms and markets, rather than only at the level of individual firms or individual sectors; assessing the potential for deficiencies in evolving risk-management practices, or broad-based increases in financial leverage, or changes in financial markets or products that increase systemic risks; analyzing possible spillovers between financial firms or between firms and markets, such as the mutual exposures of highly interconnected firms; and identifying possible regulatory gaps, including gaps in the protection of consumers and investors, that pose risks for the system as a whole.  

Two areas of natural focus for a systemic risk authority would be the stability of systemically critical financial institutions and the systemically relevant aspects of the financial infrastructure that I discussed earlier.  

Introducing a macroprudential approach to regulation would present a number of significant challenges.  Most fundamentally,  implementing a comprehensive systemic risk program would demand a great deal of the supervisory authority in terms of market and institutional knowledge, analytical sophistication, the capacity to process large amounts of disparate information and supervisory expertise.  

Other challenges include defining the range of powers that a systemic risk authority would need to fulfill its mission, and then integrating that authority into the currently decentralized system of financial regulation in the United States.  On the one hand, it seems clear that any new systemic risk authority should rely on the information, assessments and supervisory and regulatory programs of existing financial supervisors and regulators whenever possible.  This approach would reduce the cost to both the private sector and the public sector, and allow the systemic risk authority to leverage the expertise and knowledge of other supervisors.  On the other hand, because the goal of any systemic risk authority would be to have a broader view of the financial system, simply relying on existing structures likely would be insufficient.  

For example, a systemic risk authority would need broad authority to obtain information -- through data collection and reports or, when necessary, examinations -- from banks and key financial market participants, as well as from non-bank financial institutions that currently may not be subject to regulatory supervisory reporting requirements.  

A systemic risk authority likely would also need an appropriately calibrated ability to take measures to address systemic risks -- in coordination with other supervisors, when possible, or independently, if necessary.  The role of a systemic risk authority in setting standards for capital, liquidity and risk-management practices for the financial sector would also need to be explored, given that these standards have both macroprudential and microprudential implications.  

In general, much discussion will be needed regarding what can reasonably be expected from a macroprudential regime and how expectations, accountability and authorities can best be aligned.  

Important decisions must be made about how the systemic risk regulation function should be structured and located within the government.  Several existing agencies have data and expertise that is relevant to the task, and there are a variety of organizational options.    

In any structure, however, to ensure accountability, the scope of authorities and responsibilities must be clearly specified.  

Some commentators have proposed that the Federal Reserve take on the role of systemic risk authority.  Others have expressed concern that adding this responsibility would overburden the central bank.    

The extent to which this new responsibility might be a good match for the Federal Reserve depends a great deal on precisely how the Congress would define the role and responsibilities of the authority, as well as how -- on how the necessary resources and expertise would complement those employed by the Federal Reserve in the pursuit of our long-established core missions.  

It seems to me that we should keep our minds open on these questions.  We've been discussing them a good deal within the Federal Reserve System, and their importance warrants careful consideration by legislators and other policymakers.    

As a practical matter, however, effectively identifying and addressing systemic risks would seem to require the involvement of the Federal Reserve in some capacity, even if not in the lead role.  As the central bank of the United States, the Federal Reserve has long figured prominently in the government's responses to financial crises. Indeed, the Federal Reserve was established by the Congress in 1913 largely as a mean -- a means of addressing the problem of recurring financial panics.    

The Federal Reserve plays such a key role in part because it serves as liquidity provider of last resort, a power that has proved critical in financial crises throughout history.  

In addition, the Federal Reserve has broad expertise derived from its range of activities, including its role as umbrella supervisor for bank and financial holding companies and its active monitoring of capital markets in support of its monetary policy and financial stability objectives.  

In the wake of the ongoing financial crisis, governments have moved quickly to establish a wide range of programs to support financial market functioning and foster the flows of credit to businesses and households.  However, these necessary short-term steps must be accompanied by new policies to limit the incidence and impact of systemic risk.    

In my remarks today, I have emphasized the need to address the problems posed by firms that are perceived to be too big to fail, the importance of efforts to strengthen the financial infrastructure, the desirability of reducing the procyclical effects of capital regulation and accounting rules, and the potential benefits of taking a more macroprudential approach to the supervision and regulation of financial firms.  

Some of the policies I propose can be developed and implemented under the existing authority of financial regulators.  Indeed, we are in the process now of doing just that.  But in other cases, congressional action will be necessary to create the requisite authorities and responsibilities.  

Financial crises will continue to occur, as they have around the world for literally hundreds of years.  Even with the sorts of actions I have outlined here today, it is unrealistic to hope that financial crises can be entirely eliminated, especially while maintaining a dynamic and innovative financial system.  Nonetheless, these steps should help make crises less frequent and less virulent, and so contribute to a better functioning national and global economy.  

Thank you very much.  (Applause.)  

RUBENSTEIN:  Okay.  Let me remind everybody, obviously, that everything said here is on the record.  And we'll have a few questions now with the chairman that I will ask him, and then we'll go to the audience in a few minutes.  

Mr. Chairman, you said in your remarks that some of the things that you propose could be implemented now by the Federal Reserve or regulatory agencies.  Should we take it to mean that those things which can be implemented by the Federal Reserve are now going to be implemented by the Federal Reserve under your proposal?  

BERNANKE:  Yes, and I described a bit about it in my remarks.   

Two areas in particular:  We are and have already made serious efforts to step up our oversight of the systemically critical firms to ensure that they have adequate risk-management and measurement systems, make sure they have enough capital and liquidity.  And of course we're working together with the Treasury to do these current assessments that we're doing of the large banks, so that going forward we can make sure they have plenty of capital, even under an adverse macroeconomic scenario.  So we're already beginning significant work in terms of strengthening the systemically critical firms and improving their risk management and their functioning.    

The other part, which I talked about a bit in my remarks, has to do with the financial infrastructure.  A great deal of that can be done, and is being done, under Federal Reserve leadership, in most cases without government -- or without congressional intervention.  In particular, we've been working for some time, even before the crisis began, on trading platforms and central counterparties for credit default swaps, which have proved to be a problem, obviously, in the current crisis -- over-the-counter derivatives.  We are looking, as I mentioned, at the tri-party repo market and other critical elements of the financial infrastructure.    

These elements of the plumbing don't get much attention.  Most people have never heard of some of these obscure markets.  But they are absolutely critical to the healthy functioning of our system.  And the stronger and more resilient they are, the less likely it is that the failure of one firm or seizing-up of one market will spread throughout the entire system.  

RUBENSTEIN:  But on the proposals that you made where legislation is required, will the Federal Reserve be seeking this legislation in conjunction with the administration or just independently seeking this legislation?  

BERNANKE:  Well, we'll be seeking legislation certainly on our own account, but we've been in conversation with the Treasury, the -- and the government, the administration.  Administration and the Treasury will no doubt have their own program, but everything I know suggests that we'll have quite a bit of complementarity in our -- in our general approach.  So I don't expect any major disagreements.    

I think the steps that are needed to address the crisis in the short term and to make sure we don't have this happen in the future, broadly speaking, are fairly clear.  And it -- this is a matter of the will and the effort and the hard work to get them done.  

RUBENSTEIN:  If all of these steps had been in place a year ago, everything you proposed, do you think the current crisis would have been prevented or just ameliorated or just somewhat different than we have now?  

BERNANKE:  Well, I wouldn't say a year ago -- maybe a couple of years ago or three years ago.  (Laughter.)  I think that we might not have avoided a period of stress, some boom and bust.  

As I mentioned at the beginning of my remarks, I do think that the large inflows of capital into the United States and other industrial countries did generate a period of excessive risk-taking and a boom mentality, which is not -- it's part of the psychology of financial markets and probably cannot be entirely eradicated so long as we have innovative and dynamic markets.  

But having said that, I do think that if all this had been in place two or three years ago, that the -- we'd be much better off today.  

RUBENSTEIN:  You're a famous student of the Federal Reserve during the Great Depression era.  How would you say the Federal Reserve today is going things differently than the Federal Reserve you studied during the Great Depression?  

BERNANKE:  You're right that I spent a great deal of my academic career studying not just the Great Depression but the whole general issue of how financial crises and financial distress affect the overall economy.  And I must say that I always thought that I was way on the edge in terms of thinking how powerful these effects might be.  There are many people in economics who say, "Well, you can let large financial firms fail.  The market will take care of it," or "These effects are second order."    

I hope that view is no longer seriously maintained -- (laughter) -- because I must say that having seen the power of financial crisis to address and to affect not just the U.S. economy but the global economy, I'm more persuaded than ever that these effects are very real and very powerful and that in trying to address the financial crisis, we are doing the best and most effective thing we can do to help the broader economy.  

To respond to your question, I learned basically two lessons from my studies of the depression.  The first is that monetary policy needs to be supportive, not contractionary.  The Federal Reserve didn't understand what was going on.  They were pursuing very orthodox policies constrained by the gold standard.  But the effect of their policies was to create a powerful deflation of about 10 percent a year in the U.S. between 1930 and 1933, which was extremely damaging. Friedman and Schwartz were among the first to point this out in their classic 1963 book.  So one lesson to be learned is that monetary policy needs to be supportive in a period of crisis like this.    

And I'm sure everyone knows the Federal Reserve has taken this to heart.  We've been very aggressive.  We've cut rates now to -- essentially to zero.  We did that very quickly. Other countries are now following our lead.  And we are now augmenting those conventional monetary policies with new creative unconventional policies to try and have additional impact on financial conditions.  So that was the first lesson.  

The second lesson is that -- to reiterate what I said before, is that when the financial system breaks down, becomes highly unstable, then that has very severe adverse effects on the economy.    

Once again, this is something that was not handled.  The Federal Reserve did not intervene to stop the failure of about a third of all the banks in the United States.  Globally, there were massive bank failures.  I think perhaps the most critical, in May of 1931, the Creditanstalt, which was one of the largest banks in Europe, failed, which generated a wave of financial crisis around the world.  Up till early 1931, arguably the 1929 downturn was just a ordinary -- severe but ordinary downturn.  It was the financial crises and the collapse of banks and other institutions in late 1930 and early 1931 that made the Great Depression great.    

And so we must have a commitment to stabilize our banking system, to prevent the failures of any large systemically critical firms, and, going forward, to find stronger rules, regulations, mechanisms to make sure we're not put in this situation where we are dealing with these "too big to fail" firms, which is obviously very detrimental to the market discipline and to the functioning of the economy in the longer term.  

RUBENSTEIN:  Final question before we go to the audience: Right now do you see the recession we're in likely to end by the end of this year, early next year, or do you think we've hit the bottom yet, or can you say -- make any comments about the depth and length of the recession?  (Soft laughter.)    

BERNANKE:  Well, my forecasting record on this recession is about the same as the win-loss record of the Washington Nationals. (Laughter.)  It has surprised us in being more severe than anticipated.  But again, I think the main lesson that's been learned is how powerful and how pervasive these financial market effects can be.  

But the way I would phrase my answer would be to say that it depends critically on our ability to get the banking system and the financial system more broadly, not necessarily back to 2005, but back to a situation where they -- the markets are reasonably stable, and they are -- they can perform their critical function of providing credit to the economy.  If we can do that, then I think that there's a good chance that the recession will end later this year and that 2010 will be a period of growth.  

RUBENSTEIN:  All right.  Thank you.  

First question, Arnaud.  Can you -- and everybody, please identify -- give your name, identify an organization you might be might with, or if you don't have one, just give your name.   

QUESTIONER:  Mr. Chairman, Arnaud de Borchgrave, CSIS.  Since the end of the Cold War, we've been watching democratic capitalism gradually morph into casino capitalism and, since the Enron scandal, into bandit capitalism.  We've been warned time and again about derivatives being a gigantic time bomb that could really blow up the system.  Haven't we in a sense been watching capitalism sowing the seeds of its own destruction?  

BERNANKE:  I wouldn't put it that way.  I think we must -- (laughter) -- obviously I wouldn't put it that way.  I think, though, seriously, that we have to remember first of all that capitalism, broadly construed, has been an enormous success.  I mean, it has been -- in various forms it has been the source of all of -- essentially all of the remarkable growth that we've seen in the world economy in the last 150 years.  The Chinese established their growth path only once they began to adopt market mechanisms.  The United States has -- through its use of market mechanisms, has reached the level of economic sophistication and power that we have achieved.  

So capitalism, to my mind, is still easily the only real alternative for organizing economies if our goal is to improve the standards of living of average people.  

That being said, one aspect of the -- of capitalism -- and this is something that goes back, again, for hundreds of years -- is that the financial sector, while very important and critical for allocating resources to new industries, to new products, has been prone to booms and busts.  Some of them are perhaps inherent.  People differ on exactly what the sources of booms and busts are.  If you're a Minskyite, you would say it's inherent in the dynamics, the psychology of the -- of those markets.  You might -- an alternative viewpoint would be that it has to do with the governmental structure that surrounds those markets and constrains or incentivizes those markets.  

So what we're dealing with is a particular part of capitalism, which is the financial boom and bust, which has been around for a very long time.  

I think that we can use financial markets effectively to provide resources to new industries, new products, to be innovative, to drive growth, at the same time that we can at least mitigate, if not eliminate, these booms and busts and these adverse crises that we've had in the recent years.  And I've tried to give some suggestions today.  

I think, you know, if there's any silver lining to this, I hope that we will learn, you know, what mistakes were made, that we will figure out how to create a framework in which we can benefit from the vitality and creativity of the financial system without allowing it to create these highly destructive crises that we've seen like the one recently.  

RUBENSTEIN:  Right here.  

QUESTIONER:  Jim Moody, Merrill Lynch.  A great deal has been said about mark to market, and it's -- (off mike.)  Sorry.    

The mark to market rule has been both assailed as pro-cyclical and very destabilizing.  It's also perceived as something quite necessary for transparency.  Can you comment on this back-and-forth debate over that issue?  Thank you.  

BERNANKE:  Yes.  I talked about mark to market in my remarks as one of the aspects of potential procyclicality, one of the things that tends at times to increase the severity of ups and downs in the financial system and in the economy.  

First of all, let me just say that I strongly endorse the basic proposition behind mark to market, which is that we should make our financial institutions' balance sheets as transparent and as clear as possible.  It's much better -- the system works much better when investors know what firms are worth and what they're holding on their balance sheets, and increasing transparency going forward.  I didn't talk much about that today, but it's something that we as regulators are already working on, and I think there are a number of steps that can be taken in general to further increase transparency.  

So the general principle that assets should be mark to market when possible and there should be maximum transparency is one that I  certainly support.  And I would not support any suspension of mark to market, anything like that.  However, we all acknowledge, and I think even the strongest proponents of mark to market acknowledge that in periods like this, when some markets don't even exist or are highly illiquid, that the numbers that come out can be misleading, or at least, you know, not very informative, at best.  And I think we need to do a lot more to try to provide guidance to the financial institutions and to the investors about what are reasonable ways to address the valuation of assets that are being traded or -- if traded at all, in highly illiquid, fire-sale type markets.    

And that's -- I don't have a solution to that.  I do know that, as I mentioned, that the Accounting Standards Boards themselves, but also international groups like the Financial Stability Forum, are looking at this  very seriously and coming up with concrete suggestions.  And I think that we ought to -- you know, these things move slowly in general.  They're very -- a lot of deliberation.  I think given what's going on in the world, we should look to identify the weak points of mark to market and try to make some improvements on a more expeditious basis.  

RUBENSTEIN:  Alan?  

QUESTIONER:  Alan Wolff, Dewey and LeBoeuf.  Following up on David's question with respect to recovery, it goes to overcoming inertia.  We apparently are still having down -- unemployment is going to increase, according to everyone's projections.    

Our -- is our government doing enough in terms of stimulus?  Are other governments doing enough in terms of correcting imbalances?  The Chinese have put into effect several stimulus packages.  Larry Summers yesterday or the day before called upon Europeans and others to engage in additional stimulus measures.  Is enough being done to fulfill your projection of recovery in 2010?  

BERNANKE:  Well, in the area of fiscal policy, I think it should be clear that there's always a trade-off.  The fiscal stimulus that has been undertaken was scaled, on the one hand, to be big enough -- it was hoped, at least, proposed -- to make a significant dent in the recession.  It's not going to -- by itself, it's not going to restore full employment.    

But on the other side, as you look at the benefits of a stimulus program, you also have to take into account the effects on the deficits and on the debt.  And higher debts and deficits do have implications for the future.  They affect future tax rates and tax burdens, for example.  So each country has been making somewhat different judgments about the relative benefits of a fiscal stimulus now to try to address the current downturn versus the legacy of those stimulus efforts, which would be higher debts and deficits down the road.  

So from the Federal Reserve's perspective, we have tried to be relatively -- not completely insulated, because we can't do that.  In fact, last October I did say that I thought it was appropriate for Congress to look at stimulus at that time.  But the balance -- the decision about how big it should be I think ultimately really is a congressional decision, because it does involve a trade-off between these two goods -- benefits of the stimulus versus avoiding excessive debts and deficits.  

So I think that there -- important steps have been taken along those lines.  And I guess I can't say more about it than that.  

I think -- as I indicated several times in my remarks, I think the critical element, though, is making sure that we do succeed in stabilizing the financial system.  If we don't succeed in doing that, then it's going to take longer.  

We will eventually recover.  There's no question.  This economy will recover.  There's too many underlying strengths.  It's too dynamic an economy.  But it's a question of whether it happens quickly or less quickly.  And the main determinant of that, in my view, is how quickly and how aggressively we move to stabilize the financial system.  

QUESTIONER:  Do you worry more about deflation or inflation right now?  

BERNANKE:  I'm mostly worried about the broad -- about the economy.  We're not anticipating -- (laughter) -- we're not anticipating deflation.  We do think inflation's going to be quite low over the next couple of years.  But at the same time, we have to be very careful to make sure that we are prepared to withdraw monetary stimulus at the appropriate time to make sure that down the road we don't have inflation.  

So we are committed to having price stability.  We believe we're in -- we have the tools in place to do that.  But right now, both the objectives for price stability and the objectives for growth are pointing in the same direction, and that is for strong support of the economy.  

RUBENSTEIN:  In the back.  Let's go as far back as possible.    

The person, the last person, okay, standing up.    

QUESTIONER:  Yes.  My name is Dan Price.    

Mr. Chairman, on April 2nd, the leaders of the G-20 will be gathering, in London, to address issues of the global economy and financial market reform.  Could you tell us what that gathering of leaders could usefully do, to move things along, particularly on the agenda you mentioned?    

Thank you.    

BERNANKE:  Well, that's a difficult question, because there's questions of what can be accomplished in that kind of forum.  And a lot depends on the work that's being done now, in advance, by deputies and staff and finance ministers who are trying to set up the program.    

I think that from the perspective of the G-20 that the focus ought to be on the international aspects obviously of this crisis.  I talked today primarily about what the United States can do.  And I left implicit and perhaps I shouldn't have, in front of the Council on Foreign Relations, the fact that this is very much an international problem.  And it requires international solutions.    

In particular we need to work together effectively, to make sure that we have solutions for our banking systems that are not mutually inconsistent or create problems across jurisdictions.  We need to make sure that we're working together, to stabilize the banking system and to avoid the failure of systemically critical firms.    

We need to begin to establish a framework.  And I think it's asking too much for a meeting like that to come out with detailed proposals in many different areas.    

I think the better goal for a meeting of leaders would be, as much as possible, to establish some principles that would guide reforms around the world, because ultimately reforms not only have to be effective but they have to be coordinated.  They need to be -- need to work for institutions and for markets that cross borders.    

We have banks, insurance companies with subsidiaries in 100 countries or 120 countries.  And there are so many jurisdictions that  dealing with problems, at one of those companies, is extraordinarily complicated.  And in order to do that successfully, we need to have agreements, conventions that will help us work across jurisdictions, in an effective and cooperative way.    

RUBENSTEIN:  Right here.  Frederick.    

QUESTIONER:  (Off mike.)    

RUBENSTEIN:  Speak up.    

(Cross talk.)    

QUESTIONER:  Frederick Smith with PBS.    

You've talked about the need to stabilize the financial system. We've seen enormous capital flows go from the government to major financial institutions.  What is it going to take?  And what is the record so far of getting them actually to begin lending money again, so that the lubricant of the economy is working?    

BERNANKE:  So I think that the money, the capital, that has gone into the banking system has produced beneficial results.  And I would begin with the crisis, as you all remember, from mid-September to mid-October and in particular right after the G-7 meetings here in Washington on October 12th, when the G-7 leaders or G-7 finance ministers and central bank governors talked about, here in Washington, what we saw at that time as the potential for a global collapse or meltdown in our respective financial systems.    

It was immediately following that meeting that the -- many countries around the world actively inserted capital.  They improved or increased depository and other liability guarantees for banks. They provided more liquidity, as we did here in the United States. And those steps stabilized not completely but certainly stopped what would have been, in my mind, a catastrophic collapse of the global banking system.    

That alone was worth a great deal, in my view.    

Going beyond that, the additions of capital have had some effect in reducing the powerful deleveraging dynamic which is leading banks to -- not just not to make loans, but to actively shed loans in order to maintain their capital ratios.  

And finally, I think that -- going forward, I think that we will see, and are seeing, lending arising from capital injections.  Why else do banks have capital, except to provide the basis for which they conduct their business, including making new loans?  

The transparency, which is very important, is going to be enhanced.  The Treasury has explained that they will be requiring much more detailed reporting from banks that receive TARP capital about their lending environment, their lending plans and their lending accomplishments, so I think more evidence will be forthcoming.  But I think the capital that has been injected has been very well used, in the sense that it has both averted a much more severe scenario and has begun the powerful -- the important process of stabilizing the banking system.  

RUBENSTEIN:  Okay, here, go ahead.  

QUESTIONER:  Steve Charnovitz, from George Washington University Law School.  Thank you, Mr. Chairman, for your comprehensive reform.  

I had a question about the systemic risk authority.  As you've described it, it's looking at financial institutions, financial instruments -- really, the private sector.  But shouldn't an authority like that, if it's going to be forward-looking and avoid financial crises, also look at the policies of the government -- monetary policy, housing policy, trade policy, things like that?  And therefore, shouldn't this authority also be looking at the Federal Reserve, the Congress and the executive branch?  

BERNANKE:  Well, I think you're -- (chuckles) -- you're creating a number of conflicts of authority and power there.  I mean, obviously, the Federal Reserve is independent in making its monetary policies.  The Congress obviously cannot be managed by an authority that they create.  (Laughter.)  So I think, at best, that what the -- what an authority could do would be to point out potential problems, and that the appropriate authorities -- whether they be the Federal Reserve, the Congress, the administration -- address them.  

In particular, I do think that -- more specifically, I do think that this crisis has revealed some rather shocking gaps in our  regulatory oversight.  I mean, who was overseeing the subprime lenders, for example?  Who was overseeing AIG?  There simply wasn't enough adequate oversight in those cases.  And it's certainly one of the things that even a -- even if you have an oversight financial stability authority which has a relatively light mandate -- really, one just information gathering and description, rather than power, direct powers -- an authority of that type could point out and identify such gaps and call them to the attention of the Congress, and Congress could then take the necessary steps.  

So I think that you could have a part of the responsibilities of the systemic risk authority would be to try to identify problems of various kinds.  But, you know, let's be very clear.  The ultimate authorities lie in -- in the executive and legislative branches, and they would have to be the ones to decide how and whether to respond to issues that are raised by the systemic risk authority.  

RUBENSTEIN:  I think one last question from the audience. Here -- right here.  

QUESTIONER:  Mr. Chairman, Bill Arnold from Shell.  Last week the president of the New York Fed talked about stress testing the financial institutions to project 2009 losses using assumptions that are much worse than consensus -- could you -- on unemployment, GDP growth and so forth.  Could you comment on that?  

BERNANKE:  Certainly.  We're doing a supervisory assessment. We are looking at the banks on two scenarios.    

The first one is the scenario which was essentially the consensus scenario of the blue-chip private sector professional forecasters, which is an adverse scenario with rising unemployment and weak growth, but nevertheless more or less what the main baseline projection was by the private sector.  The alternative scenario is a more adverse one that involves unemployment averaging over 10 percent for a period, which we view as being certainly -- you know, it's certainly well within the realm of possibility, but it's a more adverse and less centrist kind of perspective on what the economy -- how the economy might evolve.  

This exercise will look at both mark-to-market and bank book accrual assets over a two-year horizon and try to assess how much capital and how much high-quality capital would the 19 banks that we're looking at, the 19 essentially biggest banks in the United States, how much capital would they need to be well capitalized -- not solvent, but well capitalized even in the bad scenario?    

And this assessment process, the purpose of it is to determine -- it's not a pass-fail test.  The purpose is to determine how much capital they need.  And the way the capital will be provided -- and all will receive capital as needed -- will be from the TARP program, which will provide a form of capital which is initially in preferred form, which means it's non-voting, but which can be converted as needed into common shares, which is a higher quality form of capital, as losses do, in fact, occur.  If losses don't occur, if we have a better scenario or the credit performance is better than expected, then the preferred stocks will sit there but will not have to be converted into the common.  

So, again, the purpose of this is not to pass some banks and fail others.  The purpose is to figure out how much capital each  institution needs to be well capitalized not just in the mainstream scenario but even in a more adverse scenario going forward.  

RUBENSTEIN:  Mr. Chairman, my final question would be, when you were minding your own business at Princeton and you got a call from Washington, D.C. -- have you ever had any second thoughts about your decision -- (laughter) -- to say yes?  Or are you relishing the opportunity to do the -- to deal with these challenges now?  

BERNANKE:  I must admit, when I first got the call, I said, "Gee, wouldn't it be nice to go round out my resume for a couple years and come back to Princeton?"  

But actually, you know, I do think that economics is -- it's not music or math, you know?  

It's not something that's valuable in its own -- its own -- for its own faith.  Economics is only useful to the extent that it helps people, that it helps the economy.    

I spent my entire career looking at monetary policy, macroeconomics, financial crises and their effects on the economy. And so I have, you know -- through those studies, I've learned some things, I hope, that will be helpful -- or are being helpful in the current environment.  And so I view this as a -- as a wonderful opportunity to use what I know to serve my country, to try to serve the American people.    

Yeah, I can't deny that there have been some dark days and some difficult nights and difficult weekends.  (Laughter.)  But I don't regret it, and I'm very gratified that I am able to, you know, use whatever skills, personal abilities that I have to make a difference. And I -- again, I think that should be the goal of every economist. It -- economics is not worth -- it's not worth the effort if it's not applied in a way that makes a difference in the world.  

RUBENSTEIN:  Thank you very much.  (Applause.)    

Can everybody please stay in their seats so the chairman can depart now, and just wait a few minutes until he leaves?  Okay?  

Thank you very much.  

BERNANKE:  Thank you.  Great.  

RUBENSTEIN:  Appreciate it.  Thank you.  (Applause.)

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