an efficient financial structure that has so clearly contributed to increased economic stability. dramatic changes in our financial structure have required governments to ensure that their regulatory regimes are appropriate to the current configuration of markets and institutions. in the judgment of the federal reserve, the commodity futures modernization act of 2000 struck the right balance in regulating derivatives in the united states, as did gramm - leach - bliley in finance generally. our international banking and financial system is regulated primarily by counterparties whose due diligence is fundamental to the containment of risk, including systemic risk. government regulators can exercise only broad oversight. we at the federal reserve, for example, can never bring to bear the detailed market and counterparty surveillance that private - sector players exercise. we rely on you to be, in effect, the front - line regulators. increased government regulation can cause unrealistic expectations regarding the extent to which risk can be reduced by regulators. such actions can create moral hazard and may prove counterproductive. we trust that the basel ii capital accord, when final, will be sensitive to these concerns. * * * the surge in risk hedging in recent years is a symptom of a much broader issue of change in both domestic and international finance that is a manifestation of changes in the real economy. as the pace of technological change alters the conduct of business in ways we will never fully anticipate, we must foster the ability of our ever - expanding international banking and financial system to meet the challenge of that change. the flexibility of our industry and workforce to reinvent themselves when the need arises forms the basis for increasing standards of living. this " creative destruction, " in turn, requires an effective and flexible financial system. the world's bankers are in an excellent position to develop and nurture such a system.

* in summary, because of increased access to real - time information and, more arguably, extensive deregulation and innovation in financial and product markets, economic imbalances are more likely to be readily contained. as a consequence, cyclical episodes overall should be less severe than they otherwise would be. if this is indeed the situation - - and it must be considered speculative until more evidence is gathered - the implied reduction in economic volatility, other things being equal, would lower risk and equity premiums. other things, however, may not be wholly equal. the very technologies that appear to be the main cause of our apparent increased flexibility and resilience may also be imparting different forms of vulnerability that could intensify or be intensified by a business cycle. from one perspective, the ever - increasing proportion of our gdp that represents conceptual, as distinct from physical, value added may actually have lessened cyclical volatility. in particular, the fact that concepts cannot be held as inventories means a greater share of gdp is not subject to a type of dynamic that amplifies cyclical swings. but an economy in which concepts form an important share of valuation has its own vulnerabilities. as the recent events surrounding enron have highlighted, a firm is inherently fragile if its value added emanates more from conceptual than from physical assets. a physical asset, whether an office building or an automotive assembly plant, has the capability of producing goods even if the reputation of its managers falls under a cloud. the rapidity of enron's decline is an effective illustration of the vulnerability of a firm whose market value rests largely on capitalized reputation. the physical assets of such a firm compose a small proportion of its asset base. trust and reputation can vanish overnight. a factory in such a context cannot. the implications of such a loss of confidence for the macroeconomy depend importantly on how freely the conceptual capital of the fading firm can be replaced by a competitor or a new entrant into the industry. even if entry is relatively free, macroeconomic risks can emerge if problems at one firm tend to make investors and counterparties uncertain about other firms that they see as potentially similarly situated. the difficulty of valuing firms that deal primarily with concepts and the growing size and importance of these firms may make our economy more susceptible to this type of contagion. another, more conventional determinant of stability will be the economy's degree of leverage - - the extent