formed by growth and consolidation are increasingly complex entities that create the potential for unusually large systemic risks in the national and international economy should they fail. no central bank can fulfill its ultimate responsibilities without endeavoring to ensure that the oversight of such entities is consistent with those potential risks. at the same time, policymakers must be sensitive to the tradeoffs between more detailed supervision and regulation, on the one hand, and moral hazard and the smothering of innovation and competitive response, on the other. heavier supervision and regulation designed to reduce systemic risk would likely lead to the virtual abdication of risk evaluation by creditors of such entities, who could – in such an environment – rely almost totally on the authorities to discipline and protect the bank. the resultant reduction in market discipline would, in turn, increase the risks in the banking system, quite the opposite of what is intended. such a heavier hand would also blunt the ability of us banks to respond to crisis events. increased government regulation is inconsistent with a banking system that can respond to the kinds of changes that have characterized recent years, changes that are expected to accelerate in the years ahead. the desirability of limiting moral hazard, and of minimizing the risks of overly burdensome supervision and regulation, has motivated those of us associated with the basel exercise to propose a three - pillared approach to prudential oversight. this approach emphasizes, and seeks to strengthen, market discipline, supervision, and minimum capital regulation. market discipline in trying to balance the necessary tradeoffs, and in contemplating the growing complexity of our largest banking organizations, it seems to us that the supervisors have little choice but to try to rely more – not less – on market discipline – augmented by more effective public disclosures – to carry an increasing share of the oversight load. this is, of course, only feasible for those, primarily large, banking organizations that rely on uninsured liabilities in a significant way. to be sure, these organizations already disclose a considerable volume of information to market participants, and, indeed, there is ample evidence that market discipline now plays a role in banking behavior. nonetheless, the scale and clarity of disclosures is better at some institutions than at others and, on average, could be considerably improved. with more than a third of large - bank assets funded by non - insured liabilities, the potential for oversight through market discipline is significant, and success in this area may well reduce the need to rely on more stringent governmental supervision and regulation. the channels

that banks are, and will be, using to evaluate their risk positions and the capital needed to support these risks. to spur this process in the united states, the federal reserve in june issued new examination guidance encouraging the largest and most complex banks to carry out self - assessments of their capital adequacy in relation to objective and quantifiable measures of risk. these self - assessments will be evaluated during on - site examinations and, eventually, are to be a factor in assigning supervisory ratings. a key component of these self - assessments will be each bank ’ s internal risk evaluations of the credit quality of its customers and counterparties. currently, such internal risk ratings are beginning to be used by a small number of banks in their risk - management, pricing, internal economic capital allocation, and loan loss reserve determinations. some banks are further along in the process than others. virtually all large banks are moving in that direction. the bank regulators already have begun incorporating reviews of these internal risk - rating processes into their on - site examinations, and last july the federal reserve issued examination guidance on this subject, including a summary of emerging sound practices in this area. the supervisory policies and procedures being contemplated will build on the increasingly sophisticated management and control systems that are rapidly becoming part of banks ’ best practice risk - management mechanisms. they will, as well, require both good judgment and sophistication on the part of bank examiners in order to avoid a cookie - cutter application of policies and to develop skills at evaluation that will match those available to the banks. for each of about thirty large, complex banking organizations – in washington parlance, lcbos – the federal reserve has already established dedicated teams of examiners, supplemented by experts in areas ranging from clearance and settlement to value - at - risk and credit - risk models. each lcbo team is directed by a senior reserve bank official. both that “ central point of contact ” and his or her supervisory team will be charged with following one lcbo and understanding its strategy, controls, and risk profile. jointly, these teams will represent the federal reserve supervisory pillar as it applies to lcbos. minimum capital regulation in addition to emphasizing more effective market discipline and making supervisory assessments of bank capital adequacy more risk - focused, the june consultative paper highlights the need to make regulatory capital requirements – the third pillar of prudential oversight – more risk - focused as well. in recent years, it has become clear that the largely arbitrary treatment