WASHINGTON (MNI) – The following are excerpts from prepared remarks
by Atlanta Federal Reserve President Dennis Lockhart Friday at a town
hall on Financial Capability in Atlanta:

Principles (imperatives) of financial system leadership

So let me now turn to the question of how that trust is earned, to
a regulator’s perspective on the fundamentals of system and firm-level
management to ensure trustworthiness.

Financial systems have inherent fragilities. They are networks with
complex, intricate webs of interaction and interdependence. They perform
what financial economists call maturity transformation. This means
financial institutions transform short-term liabilities, like deposits
that can be withdrawn at any time, into longer-term funding of assets,
like loans to businesses and consumers. Also, modern financial systems
involve significant financial leverage. That is to say, financial
institutions-banks, brokerages, and the like-finance their activities
with one part shareholders’ equity and multiple parts debt in one form
or another.

Financial systems are also giant information systems with
substantial, but not complete, transparency. Information moves
constantly in these systems to help people make decisions about risk.
And, in today’s world, a financial system operates on a digital
electronic backbone, vulnerable to computer and security failures.

For the public to have and keep faith in this country’s financial
system, I believe the parties at the top must meet their
responsibilities in five key areas:

– First, regulatory oversight. Here’s how I think of my
responsibility as a banking supervisor: collectively, the community of
regulators must judiciously supervise individual institutions and
vigilantly monitor the health of the overall system, to guard the public
trust and, above all, avoid a systemic crisis. This is not to say that
regulators can or should guarantee that individual firms will not fail.

Firms will fail. That reality can’t be regulated or legislated
away. But good oversight can prevent some failures.

The system we should work toward is one in which no institution is
too big to fail. Much is being done in the aftermath of the Fed’s and
the Treasury’s emergency interventions of 2008 to get to this state of
affairs, but, in my view, this is a longer-term aspiration at this
moment. I will point out, however, that in 2008 regulatory authorities
effectively had no resolution mechanism. But Dodd-Frank now provides a
framework for the orderly unwinding of a large, complex financial
institution.

– Second, ensured liquidity. The Fed is the lender-of-last-resort
for the American banking system-that is, after banks have exhausted
private-sector sources. The central bank stands ready to provide
temporary liquidity to solvent banks and other regulated entities on
terms that involve no credit risk to the Fed. That is, this credit is
fully secured by good collateral. I believe the Fed performed this role
very effectively during the financial crisis.

– Third, controlled leverage-at the system and firm level-through
adequate capitalization. Firm-level capital (and high-quality capital)
is a buffer against losses that can lead to failure. Maintaining this
buffer is especially important for the larger, systemically-important
institutions for which government intervention in a crisis might
otherwise be the only response to a threat to the entire system. We
absolutely must get to a state in which private shareholders and
creditors bear the risks of failure, not taxpayers. The public and their
elected representatives were justifiably outraged at the interventions
of 2008. As Chairman Bernanke said, the Fed intervened “holding its
nose.”

– Fourth, sound lending and business practices along with healthy
incentives for managers. The principles of sound management of financial
institutions are straightforward. They are to maintain adequate capital,
diversified sources of funding, diversified assets, rigorous standards
for underwriting risk, and solid risk management processes.

Furthermore, top managers of banks and financial institutions bear
the responsibility of cultivating an internal culture of healthy
incentives (and disincentives) for employees. Just as moral hazard
exists when managers, shareholders, and creditors believe the government
will bail out a particular firm, there is moral hazard when the income
and wealth accumulation ambitions of employees are shorter term than the
business aims of top managers and directors. In my opinion, a disconnect
exists in this regard, and this is an enduring condition that simply has
to be managed into acceptable bounds.

– And fifth, transparent markets and institutions. I believe the
aim should not be to “de-risk” our financial system. A former boss of
mine wrote a book about this titled Risk & Other Four-Letter Words. The
book’s theme was that taking risks is the business of banks and
financial firms-and, for that matter, all private-sector businesses.
There’s no moving forward without taking risk. But risk decisions should
not be blind guesses or herd-following impulses. They should be based on
sufficient information about the working of markets and the condition of
market participants. And protection on the part of regulators against
severe disruptions in systemically important financial markets requires
a high degree of transparency of trading, position taking, and
settlement.

These, then, are essential elements of the responsibilities of both
government authorities and top firm management as stewards of the
financial system. They are, in my mind, required to achieve a high
degree of resilience in an innately fragile system and preserve public
trust.

Thank you again to Samuel Jackson and the supporters of this event
for exploring the theme of financial capability. I think improvement in
this area requires efforts at both the individual level and the system
and institution level. We learned over the last decade that the lack of
financial literacy in our citizenry imperils the system, and failings of
high-level supervisors and managers can result in considerable harm to
the economy and the general public.

** Market News International Washington Bureau: 202-371-2121 **

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