these initiatives has been an increasing effort by supervisors to avoid locking themselves into formulaic, one - size - fits - all approaches to supervision and regulation. too often financial engineering has been targeted at regulatory arbitrage - - that is, the exploitation of loopholes in narrow regulatory policies are based on old traditional instruments, activities or business lines. supervisors are increasingly recognizing that the underlying risk characteristics of a financial instrument, activity or business line are of primary importance and not what they are called or officially labelled. to be sure, financial engineering can create derivative instruments which can combine component risks ( including market, credit, liquidity, operational and reputational risks ) in complex ways. but seemingly simple traditional cash instruments can actually have higher risk profiles than many instruments that are formally labelled “ derivatives. ” in fact, the categorization of financial instruments and activities without regard to their underlying risk and economic functions can actually handicap sound management. thus, federal reserve and other supervisors have increasingly issued supervisory guidance that emphasizes managing the risks involved in bank activities and de - emphasizes the supervisory focus on specific instruments or traditional products. most recently, the ffiec published for industry comment a new policy statement that would eliminate the 1992 interagency policy that instituted the ffiec high risk test. the older policy statement placed significant constraints on a depository institution ’ s holding of certain “ high - risk ” mortgage securities that met specific market risk sensitivity tests. the new policy would replace the high risk test with broader guidance on sound practices for managing all investment and end - user activities. in essence, the new statement would allow an institution to hold any bank - eligible instrument as an investment as long as the institution had an adequate risk management process commensurate with the scope, complexity, and sophistication of its investment and end - user holdings. the old ffiec high - risk tests offer an excellent case study of the potential pitfalls of narrow formulaic supervision in an age of dynamic financial engineering. by requiring a pre - purchase price sensitivity analysis, the high risk test successfully helped institutions better understand the interest rate risk of certain mortgage securities. it effectively constrained many smaller financial institutions from acquiring certain types of securities that subsequently created large losses for other investors. however, while protecting some institutions, the tests may also have distorted the investment decision making process at other depository institutions. concerns about burden and heightened examiner review of all types of mortgage securities may have led institutions to blindly eliminate them as potential investments - - regardless of the merits of their

collateral damage. i hope and anticipate that trust and integrity again will be amply rewarded in the marketplace as they were in earlier generations. there is no better antidote for the business and financial transgressions of recent years.