circumstances under which conversion is triggered? how much common equity do debt holders receive upon conversion? however, our early work on this issue suggests that contingent capital may be a promising mechanism for injecting common equity into the banking system in times of stress without unduly raising intermediation costs or pushing financial activity out of the banking sector into the unregulated sector. on the liquidity front, there are a host of initiatives underway. for starters, the federal reserve is now supervising most of the holding companies of the systemically important financial institutions. that was not true at the start of the crisis. so, for example, the holding companies of goldman sachs, morgan stanley and merrill lynch, which is now a subsidiary see, for example, senior supervisors group, “ risk management lessons from the global banking crisis of 2008, ” october 21, 2009, and “ observations on risk management practices during the recent market turbulence, ” march 6, 2008. of bank of america, are now under our direct supervision. we are making sure that they have appropriate liquidity buffers and capital. second, the federal reserve is working with a broad range of private sector participants, including dealers, clearing banks, and tri - party repo investors to dramatically reduce the structural instability of the financial system utilities, such as the tri party repo system. third, the basel committee is working on establishing international standards for liquidity requirements. there are two parts to this. the first is a requirement for a short - term liquidity buffer of sufficient size so that an institution that was shut out of the market for several weeks would still have sufficient liquidity to continue its operations unimpaired. the second is a liquidity standard that limits the degree of permissible maturity transformation – that is, the amount of short - term borrowing allowed to be used in the funding of long - term illiquid assets. under these standards, a firm ’ s holdings of illiquid long - term assets would need to be funded mainly by equity or long - term debt. 3 there is also work underway on the problem of how to ensure that financial institutions have compensation structures that curb rather than encourage excessive risk taking. this issue of compensation is obviously a hugely potent one, as there is a fundamental unfairness in what has happened over the past few years. the actions taken by the federal reserve and others to stabilize the financial system had the effect of rescuing many of the same financial institutions that contributed to this crisis. many of those

the time comes to ensure that inflation stays low and inflation expectations well anchored. as always, my comments represent my own views and opinions, not necessarily those of the federal open market committee or the federal reserve system. with the benefit of hindsight, it is clear that the fed and other regulators, both here and abroad, did not sufficiently understand some of the critical vulnerabilities in the financial system, including the consequences of inappropriate incentives, and the opacity and the large number of self - amplifying mechanisms that were embedded within the system. likewise, we did not appreciate all the ramifications of the growth of the shadow banking system and its linkage back to regulated financial institutions until after the crisis began. of course, understanding now what we did not understand then is only half the battle. we need to respond to ensure that ongoing changes in our financial system do not threaten the stability of the financial system in the future. for one, the crisis is provoking a reevaluation of our views on how to respond to asset bubbles. for years, central bank orthodoxy has been that you cannot identify asset bubbles very well. thus, the strategy has been to move aggressively to clean up such bubbles after they have burst. i think our level of confidence in that approach has been considerably reduced in the wake of the crisis that we have just experienced. the costs of cleaning up after the fact have been immense. but make no mistake – developing an effective, more proactive approach is not easy. among the important questions that need to be answered : 1. how does one identify bubbles – which i ’ ll define here as persistent large deviations in asset prices from their fundamental value – in real time? 2. what instruments can be used to limit the development of bubbles and / or allow bubbles to deflate in non - catastrophic ways that will not damage the economy in other ways? turning to the first issue, identifying asset bubbles in real time is difficult. however, identifying variables that often are associated with asset bubbles – especially credit asset bubbles – may be less daunting. to take one recent example, there was a tremendous increase in financial leverage in the u. s. financial system over the period from 2003 to 2007, particularly in the nonbank financial sector. this sharp rise in leverage was observable. presumably, this rise in leverage also raised the risks of a financial asset bubble and the impact of this bubble on housing certainly raised the stakes for the real economy if such a