, however, regulators were coming to regard capital requirements as a supple prudential tool. as activity and, eventually, affiliation restrictions were loosened, capital requirements seemed a promising way to provide a buffer against bank losses from any activities in which the bank or its affiliates might engage. support also developed for the proposition that minimum capital levels could, by maintaining a material equity value for the bank, serve as a disincentive for excessive risk - taking by management and shareholders. as the activities and affiliations of banks became increasingly complex, regulators also relied more on focused supervisory attention to the specific risks of each institution. similarly, they demanded that banks enhance their own internal risk - management systems. as with capital requirements, regulators reasoned that a good risk - management system could effectively promote bank stability in the face of quickly changing bank activities. the two regulatory trends – seeking greater risk - sensitivity in capital requirements and greater effectiveness of internal risk - management systems – came together in basel ii's advanced internal ratingsbased approach to capital regulation. thus, at the onset of the current crisis, the financial regulatory system had accommodated the growth of capital market alternatives to traditional financing by relaxing some restrictions on bank activities and virtually all restrictions on affiliations between banks and non - bank financial firms. in place of the superseded restrictions were capital requirements focused on credit and market risk, along with a greater emphasis on supervision and risk management, especially at larger firms. these legal changes facilitated a wave of mergers and acquisitions that created a number of very large, highly complex financial holding companies centered on a large commercial bank. these were subject to prudential regulation. at the same time, there was a group of very large, significantly leveraged " free - standing " investment banks whose market practices were regulated by securities laws, but were not subject to prudential regulation. the imperative of regulatory reorientation there were, of course, many ways in which this financial regulatory system fell short of the objectives of maintaining stability in the financial system. any one explanation inevitably oversimplifies what was a complex and long - developing set of vulnerabilities. however, as i have earlier suggested, i believe an analysis can be profitably organized around the premise that the regulatory system did not come close to adequately accounting for the impact of trading and capital market activities on both traditional banking and systemic risk. this basic point was manifest in three important deficiencies of the prevailing regime : the shortcomings of microprudential regulation, the

either a complement to, or partial substitute for, existing capital rules. another example is the idea that certain short - term wholesale funding channels might be guaranteed, perhaps in connection with specific forms of securitization activities, in exchange for an insurance premium and regulatory requirements. finally, there are some options that are considerably more dramatic. proposals to limit the size ( or interconnectedness ) of financial institutions would represent a historic break with how we have regulated the financial system. 9 for that reason alone, as well as the potentially enormous consequences of such measures, this is not an idea that should be advanced lightly. however, if one accepts the basic premise that our financial system will remain healthy only if the too - big - to - fail problem is addressed in a muscular way, this kind of idea has at least heuristic value in making us think hard about the degree to which the regulatory path we set for ourselves is leading to the proper destination of greater financial stability. the statutory prohibition upon interstate acquisitions that would result in a commercial bank and its affiliates holding more than 10 percent of insured deposits in the united states is the closest instance of this approach in current law. see 12 u. s. c. § 1842 ( d ). conclusion i have noted the observation of a number of thoughtful commentators that, given the continuing difficulties in credit markets, we need not rush to reform our regulatory system. while i certainly agree with the propositions that we are unlikely to see widespread financial excesses in the near term and that we must get reform right, i believe it is essential to move forward now. history shows that opportunities for real reform are often short - lived. momentum can too easily be lost, and the return of better times too easily leads to complacency. if we are to spare the next generation the pain and loss caused by a financial crisis, we must not only learn lessons. we must act on them.