NEW YORK – In the aftermath of the financial crisis, rebuilding the financial system, with proper supervision of it, is critical, Federal Reserve Bank of Kansas City President and Chief Executive Officer Esther L. George said Wednesday.

“We now face a real challenge in rebuilding our financial system and its supervisory framework,” she said in a speech in New York, according to prepared text released by the Fed. “The steps we take today will either serve us well in the inevitable future financial shock, or they will sow the seeds of the next crisis. If we are to be successful, though, we must stop and ask ourselves what really went wrong this time and what can we do to construct a more stable and resilient financial system.”

The pattern of the crisis, George said, included “an inability or unwillingness to see the warning signs and take preventative action, followed by massive damage, and then working through the emergency policy steps and the rebuilding of our financial system.”

The damage, she said, shows the potential of “a financial sector with too much leverage and risk.”

And, while there will be future crises, “public policy and preventative steps play an important role in establishing the overall stability and resiliency of our financial system.”

The price of failure could be “an even more severe crisis,” George said.

Policymakers tend to “become reluctant when it is time to make the hard judgments about effective reforms and instituting greater risk restraints,” she added, noting “signs of this are already occurring with the efforts by financial institutions and others to weaken or delay stronger capital standards and other provisions of the Dodd-Frank Act.”

To strengthen the financial system, George said, the major need is “to correct the misaligned incentives and the improper expansion of federal safety net protections that encouraged and enabled institutions to take excessive risks.”

Supervisors must exercise “sound judgment” and make “informed decisions,” as opposed to the recent slide of supervisors into a more passive role “monitoring regulatory compliance and tracking the risk-management practices adopted by financial institutions.

“This link between large institutions and special public support has left us trapped in a pattern in which public authorities believe they must expand the safety net each time a crisis is brought on by excesses in risk-taking at large institutions. This broadening of the safety net facilitates the next and even more severe crisis, as new moral hazard issues are introduced and major institutions are left with greater incentives for taking on risk. The critical and defining question for us is how to break this pattern of growing safety nets and escalating crises, while restoring much-needed market discipline to the financial system,” George said.

George advocates eliminating too big to fail policies. “This crisis provided overwhelming evidence that the ingrained response of policymakers is to treat our largest institutions as being TBTF. With the help of bailouts, TARP money, the discount window, accommodative monetary policy and other actions, our largest institutions not only survived the crisis, but in many cases, emerged as even larger players in the financial system. The funding, capital and other advantages that TBTF provides are enormous, and such advantages—as seen in this crisis—remove important constraints on risk-taking that financial institutions would otherwise face from their stockholders, creditors and uninsured depositors.”

She called Dodd-Frank’s provisions “for resolving the failure of a systemically important organization … the first, and perhaps easiest, step in dealing with TBTF.”

Also, bank capital standards need to be strengthened, particularly “leverage requirements tied to equity capital,” George said. “In addition, we should weigh carefully the lengthy transition period contemplated by Basel III. There is risk that banks will be caught short again if we adopt a lengthy phase-in period and let banks manage their capital down to the minimum transition standards through substantial dividend payouts and stock buybacks.”

Two reasons George gave for being “cautious about relying heavily on risk-based capital standards” were: “banks have been quick to arbitrage whatever risk-based standards are in place, and second, it is hard to say that our risk weights have been accurate measures of risk.”

Subscribe Now

Independent and authoritative analysis and perspective for the bond buying industry.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.