long - term economic interests of the united states. we need a banking system that is not only sound but also able to innovate and respond to customer needs. the question for us is how best to accommodate change while protecting the public interest. in my comments today, i would like to draw upon some of our past experiences and outline a conceptual approach for addressing future issues. even a casual observer of banking history will recognize that many of the matters we deal with – and perhaps the most important ones, in particular – are largely variations of older and more familiar themes. that may be because the fundamental nature of banking and its role in a modern economy have not changed materially for generations, despite the important operational changes taking place every day. however, the management and supervision of banking – especially bank risk - taking – is in the process of fundamental change. the role of bank supervision and regulation as we consider the challenges ahead, it seems useful to remind ourselves of bank regulators ’ underlying directives, which i would describe as : first, to promote and enforce sound practices so that banks do not present unacceptable threats to u. s. or world financial markets or impose unacceptable costs on the insurance funds and, ultimately, the u. s. taxpayers. and second, to maintain a supervisory and regulatory environment that encourages innovation and efficient competition in financial services and that does not require excessive risk - taking by banks in order to generate competitive returns. reducing the broad objectives of bank supervisors and regulators to two sentences may be difficult, given the many demands placed on them in overseeing a business as dynamic and important as banking. yet, in some respects, these statements could be simplified still more : to promote safety and soundness while allowing banking institutions to innovate and compete. there are clearly some tensions in these goals. the hard part, of course, is in implementing these concepts on a daily basis. can we always tell, for example, what is “ unsafe and unsound ” when we see it, and at what point do we interfere with management ’ s judgment when we disagree? what is “ efficient competition ” when banks have access to a subsidized safety net? and how do we judge the competitiveness of a bank ’ s returns? reaching clear agreement on such questions is not easy, even among bank regulators with generally common goals. resolving them becomes far more contentious when bankers weigh in with materially different views. one approach is for regulators to be permissive, unless it is clear that established public

##ended acceptance of risk and hence should reduce the pro - cyclical behavior that has characterized banking history. but, again, the process has just begun. the federal banking agencies are trying to generalize and institutionalize this process in the current efforts to reform the basel capital accord. the proposed foundation approach, intended mainly for regional banks, and the advanced internal risk - based approach, intended mainly for large, complex banking organizations, would require banks to create and use internal risk classifications for their banking book. these classifications would not only be used to establish minimum regulatory capital, but the associated risk profiles would be disclosed by the bank for the review of its creditors and shareholders. how well this process works will depend on the supervisors ’ skill and, for lack of a better word, toughness in validating the conceptual and empirical basis of the risk classifications and management system. a weak or misused classification system would destroy the process. if applied seriously, and when operational near the middle of this decade, the revised accord, basel ii, promises to promote not only better risk management over a wider group of banks but also less - intrusive supervision once the risk management system is validated. it also promises less variability in loan policies over the cycle. to be sure, banks ’ risk appetites can change as they decide to increase or decrease the riskiness of their loan portfolios. in addition, minimum regulatory capital might tend to be pro - cyclical as loans migrate from less - to more - risky classifications as the economy weakens, in the process increasing minimum capital requirements. this tendency must, however, be balanced against what should be the reduction in cyclical reserving and write - offs that traditionally have come with the late recognition of excess risk taken earlier. moreover, if, as promised, better risk - management reduces the variance of charge - offs and earnings, bank equity values, to repeat, are likely to be rewarded with higher price - earnings ratios. put somewhat differently, better risk management and supervision may well focus bank management on its real objective : maximizing shareholder wealth. building on market practice in setting boundaries and minimum standards for banks, we typically look at industry practices to identify what works well and what does not. in almost all cases, that ’ s the correct approach – to build on industry practice. indeed, the development of the basel ii capital proposals i have just discussed has been constructed on the principles developed initially by the best - practice banks. we should encourage all banking organizations to continually strengthen their