Basel II provides a much better way of determining the appropriate level of capital to hold against risk. It does a better job of capturing default risk and the true extent of risk transfer in securitization, guarantees and credit derivatives. It provides explicit recognition of operational risk, which can be larger than exposure to market risk for some complex financial institutions, not just for processing or clearing banks. But Basel II is not the end of the process of designing a better regulatory framework for capital in financial institutions. As we move to refine and implement the Basel II framework for credit and operational risk, we need to strengthen the framework for market risk and encourage further improvements in how firms capture the possibility of extreme events. The current regulatory treatment of market risk does a good job of capturing directional risk from movements in interest rates, exchange rates and equity and commodity prices. It is less effective, however, in capturing the full range of risks associated with some newer products and trading strategies, where values can react sharply and discontinuously. In particular, the risks of trading strategies based on changes in the correlation between asset returns are not always captured under the current regulatory capital regime, nor are some of the risks associated with traded credit products. And given the relatively short history of some of these products, the current regulatory treatment of market risk may not capture the risks of these products going forward.

But the transitions to a more sustainable equilibrium could also bring greater volatility in asset prices, less stability in macroeconomic outcomes, slower growth and more uncertainty. The strength of the financial system is an important factor in assessing the probabilities associated with, and the potential impact of, the greater volatility that might be associated with these transitions. Where financial systems are strong and resilient, they provide more of a cushion against shocks and help improve the effectiveness of monetary policy in those circumstances. Where they are weaker, they can amplify the impact of shocks on macroeconomic activity and reduce the effectiveness of monetary policy in mitigating shocks. I believe the changes in the U.S. financial system over the past two decades have produced a stronger and more stable system. The large financial institutions at the core of the system have substantial capital cushions and larger and more diversified earnings capacity. These institutions maintain capital above both the regulatory minimums and their internal economic capital measures. The technology and practice of risk management has improved dramatically. All types of risks in financial intermediation are more broadly dispersed. The financial infrastructure is stronger. The combined effect of these changes seems likely to have made the U.S. financial system more stable across a broader range of circumstances. Although a substantial degree of uncertainty surrounds any forward looking judgment about financial resilience, the U.S. financial system seems less vulnerable to specific shocks and better able to absorb larger shocks than was true in the relatively recent past.