reserve and many private forecasters, states and localities may start to get a little breathing space. tax collections will rise with income and spending, and the use of medicaid and other income support programs should ease as the labor market improves. however, because the pace of near - term economic growth expected by most forecasters is relatively modest given the depth of the downturn, some time will likely be required before state and local fiscal conditions return to something approximating normal. continued evidence that states and localities are addressing fiscal shortfalls should help calm the municipal bond market. generally, that market seems to be functioning reasonably well. around the turn of the year, though, investor concerns about the fiscal situations of many governments, including those of some populous states, resulted in increased yields on municipal bonds relative to treasury bonds as well as a widening of credit default swap spreads for a number of states. fortunately, although these measures of risk in the municipal bond market remain elevated, they have been looking somewhat better recently, presumably reflecting expectations of continuing improvement in the finances of states and localities. the federal reserve will continue to monitor the municipal bond market closely. longer - run fiscal challenges for states and localities although my focus thus far has been on the near term, state and local governments are also confronting some difficult fiscal challenges in the longer term. indeed, with the retirement of public employees who are part of the baby - boom generation and the continued rise in healthcare costs, meeting obligations for pension and retiree health - care expenses will become increasingly difficult for many states and localities. estimates of state and local governments ’ unfunded pension liabilities for the nation as a whole span a wide range, with some researchers putting the figure in the neighborhood of $ 2 trillion to $ 3 trillion. 2 some governments are beginning to take difficult steps to address this problem, although their ability to change plan provisions is limited by the strong legal protection ( including, in some states, constitutional protection ) accorded to accrued pension benefits of public employees in many jurisdictions. 3 state and local governments also will have to address the burgeoning costs of retiree health benefits. estimates of these costs are subject to substantially greater uncertainty than are those for pension liabilities, largely because of the difficulty inherent in projecting overall health - care costs decades into the future. in addition, retiree health plans generally do not have the same degree of explicit protection as do pensions and thus may be more subject to change. with these uncertainties in mind, the prospective costs

per unit of assets, reducing their usefulness as an indicator of bank failure – a classic goodhart ’ s law. indeed, that was precisely the rationale for seeking risk - sensitivity in the basel framework in the first place. a formulation which would avoid this regulatory arbitrage, while preserving robustness, would be to place leverage and capital ratios on a more equal footing. that is why, in its recommendations on macroprudential instruments, the bank of england ’ s financial policy committee has given capital and leverage ratios equal billing. 21 wall street reform and consumer protection act, section 171. basel committee on banking supervision ( 2012 ). bank of england ( 2012 ). bis central bankers ’ speeches the evidence presented here suggests that there may also be a case for reconsidering the measurement of equity capital. basing this on market values rather than accounting cost is not only simpler, but appears superior as a guide to banks ’ dynamic viability. certainly, adding market - based indicators of capital adequacy to regulators ’ and investors ’ indicator set would seem worthwhile. 22 on calibration, at present basel iii rules prescribe a 3 % leverage ratio – that is, banks ’ equity can in principle be leveraged up to 33 times. most banks would say a loan - to - value ratio of 97 % was imprudent for a borrower. a 3 % leverage ratio means banks are just such a borrower. for the world ’ s largest banks, the leverage ratio needed to guard against failure in this crisis would have been above 7 %. the leverage ratio that would have minimised type i and ii crisis errors is around 4 %. both lie well above the current basel backstop. ( c ) pillars 1, 2 and 3 the tower of basel is underpinned by three pillars : pillar 1 ( regulatory rules ) ; pillar 2 ( supervisory discretion ) ; and pillar 3 ( market discipline ). to date, the weight borne by these three pillars has been heavily unbalanced, with most of the strain taken by pillar 1. simplifying pillar 1 rules would help rebalance the basel scales. that would not only strengthen pillar 1, but could simultaneously strengthen pillars 2 and 3. a rebalancing away from prescriptive rules provides greater scope for supervisory judgement, pillar 2. in other professions, such as medicine, prescriptive rules have generated a wood - from - trees problem. they have also caused defensive, backside - covering