explicitly to quantify their credit, market, and operating risks, by estimating loss probability distributions for various risk positions. enough economic, as distinct from regulatory, capital is then allocated to each risk position to satisfy the institution ’ s own standard for insolvency probability. within credit risk models, for example, capital for internal purposes often is allocated so as to hypothetically “ cover ” 99. 9 percent or more of the estimated loss probability distribution. these internal capital allocation models have much to teach the supervisor, and are critical to understanding the possible misallocative effects of inappropriate capital rules. for example, while the basle standard lumps all corporate loans into the 8 percent capital “ bucket ”, the banks ’ internal capital allocations for individual loans vary considerably - - from less than 1 percent to well over 30 percent - - depending on the estimated riskiness of the position in question. in the case where a group of loans attracts an internal capital charge that is very low compared to the basle eight percent standard, the bank has a strong incentive to undertake regulatory capital arbitrage to structure the risk position in a manner that allows it to be reclassified into a lower regulatory risk category. at present, securitization is, without a doubt, the major tool used by large u. s. banks to engage in such arbitrage. regulatory capital arbitrage, i should emphasize, is not necessarily undesirable. in many cases, regulatory capital arbitrage acts as a safety - valve for attenuating the adverse effects of those regulatory capital requirements that are well in excess of the levels warranted by a specific activity ’ s underlying economic risk. absent such arbitrage, a regulatory capital requirement that is inappropriately high for the economic risk of a particular activity, could cause a bank to exit that relatively low - risk business, by preventing the bank from earning an acceptable rate of return on its capital. that is, arbitrage may appropriately lower the effective capital requirements against some safe activities that banks would otherwise be forced to drop by the effects of regulation. it is clear that our major banks have become quite efficient at engaging in such desirable forms of regulatory capital arbitrage, through securitization and other devices. however, such arbitrage is not costless and therefore not without implications for resource allocation. interestingly, one reason why the formal capital standards do not include very many risk “ buckets ” is that regulators did not want to

long as we adhere in principle to a common prudential standard, it is appropriate that differing regulatory regimes may exist side by side at any point in time, responding to differing conditions between banking systems or across individual banks within a single system. perhaps the appropriate analogy is with computer - chip manufacturers. even as the next generation of chip is being planned, two or three generations of chip - - for example, pentium iis, pentium pros, and pentium mmxs - - are being marketed, while, at the same time, older generations of chip continue to perform yeoman duty within specific applications. given evolving financial markets, the question is not whether the basle standard will be changed, but how and why each new round of change will occur, and to which market segment it will apply. in overseeing this necessary evolution of the accord, as it applies to the more advanced banking systems, it would be helpful to address some of the basic issues that, in my view, have not been adequately addressed by the regulatory community. in so doing, perhaps we can shed some light on the source of our present concerns with the existing capital standard. there really are only two questions here : first, how should bank “ soundness ” be defined and measured? second, what should be the minimum level of soundness set by regulators? when the accord was being crafted, many supervisors may have had an implicit notion of what they meant by soundness - - they probably meant the likelihood of a bank becoming insolvent. while by no means the only one, this is a perfectly reasonable definition of soundness. indeed, insolvency probability is the standard explicitly used within the internal risk measurement and capital allocation systems of our major banks. that is, many of the large banks explicitly calculate the amount of capital they need in order to reduce to a targeted percentage the probability, over a given time horizon, that losses would exceed the allocated capital and drive the bank into insolvency. but whereas our largest banks have explicitly set their own, internal soundness standards, regulators really have not. rather, the basle accord set a minimum capital ratio, not a maximum insolvency probability. capital, being the difference between assets and liabilities, is of course an abstraction. thus, it was well understood at the time that the likelihood of insolvency is determined by the level of capital a bank holds, the maturities of its assets and liabilities, and the risk