capital be totally eroded if 10 percent of its loan portfolio were to become a total loss to the bank? or would it still be solvent if the loss were 20 percent, or 30 percent? what the stress test cannot tell you, is what the loss is likely to be. this is the misapprehension which is reflected in most commentary you will see on stress tests. the tests which the federal reserve conducted a year ago offered no reassurance, because even before the test results were made public, the actual extent of loss had exceeded the assumptions of the most severe test. properly used, however, stress tests are helpful in identifying the areas of financial activity where the institutions under scrutiny are most at risk, and they can help in signalling when policy intervention may be needed to address these areas of vulnerability. the quest for financial stability led to an intensive world wide review of systems for the oversight of banks and other financial institutions. the previous guidelines for the supervision of banks, developed through collaborative efforts of banking supervisors under the auspices of the bank for international settlements ( known as the basel accords for banking supervision ; the bis is headquartered in basel ), were revisited, and new guidelines proposed, incorporating more sophisticated risk management techniques and procedures. the new guidelines provided explicitly for the use of financial market institutions such as credit rating systems to be used in assessing risk. after incorporating comments from a global review process, the revised framework for global banking supervision was promulgated as a new accord on international banking supervision principles, known popularly as basel ii. unfortunately, just as the movement to upgrade banking supervision to basel ii standards started to gather momentum, the world financial markets collapsed into the mother of all recent financial crises. what will remain of basel ii in the wake of the financial crisis is as yet unclear. some commentators, including our own avinash persaud, have argued that some underlying principles of the basel accord are fundamentally flawed, a view which i happen to share. the caribbean centre for money and finance, where i worked prior to taking up my present post, will this year publish views of professor persaud and others on the flaws in the global regulatory approach that need to be addressed, going forward. the importance of financial stability it has been widely observed that financial crises are almost always accompanied by exchange rate crises, resulting in large devaluations of the domestic currency. in open economies that is not a coincidence : the failure of important financial institutions too often leads to a loss of confidence in the

an asymmetrically quick manner, since banks are forced to take immediate action to counter the shortage in funding liquidity. in addition, once confidence is lost, it takes a long time to restore the eroded confidence. as market participants explain, the credit line can be cut off at once, but the reestablishment of the credit line takes a much longer time. issues related to monetary policy mop - up operations given the understanding on the risk - taking channel i have discussed so far, what consequences will follow from the asymmetric monetary policy responses before and after the burst of a bubble? suppose a central bank is considered to make a commitment to refrain from taking any monetary policy responses until the burst of a bubble, the private agents will surely take action based on such unfounded expectations. that will accelerate maturity mismatches and asset price increases, thus further accelerating the bubble and the adverse consequences of its burst. one of the basic messages from standard new keynesian macroeconomics is that “ the policy commitment is effective in stabilizing the economy, given the forward - looking behavior in the private sector. ” standard new keynesian macroeconomics does not incorporate the risk - taking channel, but its basic message suggests the importance of the symmetric monetary policy responses to a bubble. extra operations then, what is an idea about extra operations against a bubble? i agree with the principle that monetary policy should respond to asset price movements, whether driven by the fundamentals or not, only to the degree that those movements have implications for future inflation and economic growth. i should also say that the real issue here is how to understand the expression of “ only to the degree that asset price movements have implications for future inflation and economic growth ” in implementing monetary policy. the transmission dynamics of the risk - taking channel, i have just mentioned, differs significantly from those of the standard interest rate channel through housing investment and capital investment. the risk - taking channel produces asymmetric effects between the initial positive impact and the later negative impact. and, more importantly, it also accompanies considerable uncertainty about the timing when negative impacts occur. given such nature of the risk - taking channel, conventional macroeconomic models in a central bank ’ s toolkit do not sufficiently incorporate the effects stemming from maturity mismatches and asset prices in the short term as well as in the longer term. policy challenges for central banks in light of the previous discussion, i will raise some issues for discussion regarding the actions by central banks.