to hold sufficient capital to protect against potential losses. financial stability is enhanced when banks'regulatory capital measures adequately reflect risk, as well as when banks continually improve their riskmanagement practices. since the basel ii regime is far superior to the current basel i regime in aligning regulatory capital measures with risk and fostering continual improvements in risk management for our largest and most complex banking organizations, i believe it will contribute to a more resilient financial system. reasons for basel ii the federal reserve believes very strongly that prudent and risk - sensitive regulatory capital requirements are integral to ensuring that individual banks and the financial system have an adequate cushion against losses, particularly during times of financial or economic stress. this strong belief is what motivated the federal reserve in the late 1980s to play a leading role in both negotiating the first international capital accord – basel i – and supporting implementation of the accord in the united states. in light of our role in developing basel i, let me explain why the federal reserve now supports moving to basel ii. first, although basel i was a major step forward in capital risk sensitivity at the time, rapid and extensive evolution in the financial marketplace has substantially reduced the effectiveness of the basel i rules for some u. s. banking organizations. the current basel i regulatory capital rules are increasingly inadequate for large, internationally active banks that offer ever more complex and sophisticated products and services in an extremely competitive environment. the flaws of the existing basel i rule for large, complex u. s. banks are fairly well - known. the simple risk - bucketing approach in the existing basel i rule, for example, creates perverse incentives for risk - taking. this approach – in which ( 1 ) the same amount of regulatory capital is assessed against all unsecured corporate loans and bonds regardless of actual risk, ( 2 ) all unsecured consumer credit card exposures are treated equivalently, and ( 3 ) almost all firstlien residential mortgage exposures are deemed equally risky – provides incentives for banking organizations to shed relatively low - risk exposures and acquire relatively high - risk exposures within each of these asset classes. the existing basel i rule also ignores important elements of credit - risk mitigation – such as most forms of collateral, many guarantees and credit derivatives, and the maturity and seniority of an exposure – and thus blunts bank incentives to reduce or otherwise manage risk. moreover, basel i is particularly inadequate for dealing with capital - markets transactions, such as repurchase agreements, securities borrowing and

need to take the important next step of actually implementing basel ii for u. s. banking organizations. once we do so, i believe that we can effectively manage the issues that arise, given our past experience with cross - border supervision. in addition, some concerns have been voiced that adoption of a new capital framework for the largest and most complex u. s. banking organizations could disadvantage other u. s. banking organizations, particularly the smaller banks. in this regard, the basel ia proposal was designed to modernize the existing basel i framework in the united states and improve its risk sensitivity, without making it overly burdensome or complex for banks that are comparatively smaller and less complex. moreover, basel ia would not be required ; smaller banks that wish to stay on the current basel i framework would be allowed to do so. we are keenly aware of the need for capital requirements to make sense from the standpoint of both safety and soundness and competitiveness ; we recognize that a one - size - fits - all approach is probably not feasible in this country, in light of our wide range of institutions. we remain sensitive to the principle that if we have multiple regulatory capital frameworks, they must work together to improve the safety and soundness of our entire banking system without artificially creating competitive inequalities. i want to emphasize that, amidst all of the detailed discussions and comments surrounding basel ii, the federal reserve continues to believe that strong capital serves the united states'interest in maintaining the safety, soundness, and resiliency of our banking system. we also know that banks maintain capital above these regulatory minimums in order to capture their full risk profiles, since minimum capital requirements do not necessarily cover all risks to which a given bank may be exposed. banks also hold capital above regulatory minimums to support their strategic objectives. they know that customers, counterparties, creditors, and investors take into account overall bank capital adequacy when making investment or other business decisions. in addition, banks hold excess capital to be able to respond to potential business - expansion opportunities and to be able to manage the ups and downs of market - and credit - risk cycles. these market - based incentives should not change under basel ii. indeed, i believe that greater transparency under pillar 3 will enhance the role of market incentives in ensuring that banks hold sufficient capital. by helping banks absorb unexpected losses, strong capital reduces the moral hazard associated with the federal safety net. a key lesson of the banking and thrift crises