william j mcdonough : the review of the capital accord remarks by william j mcdonough, president and chief executive officer of the federal reserve bank of new york, before the eleventh international conference of banking supervisors, held in basel, 20 - 21 september 2000. * * * i am greatly honored to be here as chairman of the basel committee on banking supervision. i ’ d like to begin by thanking the swiss national bank, kurt hauri and the swiss federal banking commission, and andrew crockett and the bis for organizing and hosting this important conference. they ’ ve done a wonderful job, for which i know we ’ re all very grateful. it is also a great pleasure to be with you under such dramatically different circumstances than when we last gathered together. just two years ago, turbulence in the financial markets around the world had affected, in one way or another, the banking systems of virtually every nation, and bank supervisors were struggling to preserve confidence and stability. today, of course, the global financial situation is much more stable and the outlook is very favorable. in the united states, we continue to enjoy the longest economic expansion in our nation ’ s history, and, following passage of financial modernization legislation, banks and other financial institutions now enjoy unprecedented strategic opportunities. in europe, following monetary union in january of 1999, the banking industry, along with other corporate sectors, is becoming more efficient and competitive as economic and political reforms have sharpened the focus on shareholder value. in asia, and in many emerging market economies, meaningful headway has been made toward recapitalizing banking systems, ridding banks ’ balance sheets of problem assets, and improving supervisory and regulatory frameworks. as a result, economies are growing again, equity markets have rebounded, and foreign capital has begun to return. what a difference two years of hard work can make. when i last addressed this conference in october of 1998, i said that bank supervisors have a special role in maintaining financial stability, and that our special role has two components : facilitating the resolution of problems when they occur, and taking the necessary steps to lower the risk of problems occurring. two years ago we were busy with the first component – crisis management and resolution. today, as we stand on the threshold of a new century, we have the opportunity to focus on the second – prevention. with that in mind, it is my view that the greatest challenge to the long - term goal of financial stability, both locally and globally, is the accelerating pace of

extent to which maturity transformation and financial intermediation had migrated outside of commercial banks. the growth of what we call the shadow banking system occurred largely without the types of safeguards – robust prudential regulation, deposit insurance, lender of last resort – that have safeguarded the commercial banking system from the types of widespread panics and runs that are capable of destabilizing the financial system. the systemic risk created by this gap in coverage was not well recognized by regulators or the private sector prior to the global financial crisis. market participants had little incentive to internalize the negative externality of the run - risk created by their collective choice of finance, and they made erroneous assumptions about the liquidity of asset markets and the capacity and willingness of banks to distribute central bank liquidity to the wider financial system during periods of stress. because the boom years resulted in strong earnings, low price volatility and few credit losses, firms were able to operate at extreme levels of leverage. when housing prices started to decline, the vulnerabilities of this type of business model soon became apparent. heavy reliance on short - term wholesale funding exposed the system to a series of intertwined downward spirals in asset and funding markets. this spread in waves. it began in the market for asset - backed commercial paper ( abcp ) issued by off - balance - sheet conduits, and spread via auction - rate securities to the repo, money market and financial commercial paper markets that formed the core financing for market - based financial intermediation. initial declines in asset prices especially for mortgage related assets forced leveraged holders with maturity mismatches to sell assets. this increased price volatility and further reduced the value of the assets that collateralized other firms ’ borrowings. higher volatility led banks and secured lenders to raise margins, while concern about counterparty risk and their own funding needs made banks reluctant to on - lend liquidity. the resulting higher margins on repo and increased collateral calls due to credit ratings downgrades reduced the quantity of assets that could be financed in repo markets and elsewhere, prompting further asset sales. as wholesale investors started to exit, this set in motion a bad dynamic – a fire sale of assets that cut into earnings and capital. this increased the incentives of investors to run and for banks to hoard liquidity against the risk that they could themselves face a run. this downward spiral of fire sales and funding runs was a key feature of the financial