requirements that would otherwise occur without the better risk - management techniques required under the proposed basel ii. the response to more formal risk management thus creates the reasonable prospect of reducing concerns about the pro - cyclicality of capital ratios under basel ii. in the past, problems have arisen when banks have been too complacent in their judgments of risks during good times, too slow to react when the situation turns, and too risk - adverse once their losses have turned out larger than anticipated. a process that encourages banks to think more carefully and more pro - actively about all of these possibilities offers the hope of a significant improvement in the way that they manage themselves over the course of the business cycle. along these lines, basel ii emphasizes the importance of stress testing credit - risk measurements. stress testing as a means for considering how risk assessments and capital requirements can change as the economic environment weakens is a necessary part of the broader shift toward a more proactive approach to risk management. bank managers should consider the results of their stress testing when determining how much capital they need to hold above the regulatory minimum requirement, which is after all only a portion of the total capital held. indeed, to facilitate flexibility and to enhance their competitive positions with counterparties, banks will continue, even after the basel ii proposal becomes effective, to carry a buffer stock of capital - an amount above their regulatory minimum. however, under the proposal, the supervisor will incorporate stress testing as a factor in the assessment of how much buffer capital should be held. as part of the second pillar of basel ii, supervisors will discuss the results of the stress test with bank management to ensure that the banks take seriously their need to consider the dynamic management of their capital over the economic cycle. operational risks my comments have focused on risk management and the cyclicality of a risk - sensitive capital regime. but thus far i have emphasized the major risk that most banks face - credit risk. at times, however, other risks have proven to be quite costly - sometimes fatal - to banks. in my view, therefore, a discussion of risk management is incomplete without a consideration of operational risk. from a bank's and a supervisor's viewpoint, no matter how real and serious operational risk may be, it is, with the current state of the art, not easy to measure. thus, the basel committee's proposal to apply an explicit capital requirement under pillar i to operational risk has been controversial. against that background, reviewing the committee's thinking that led to

s momentum. the downside risks, if they materialize, could weigh on economic activity. basic principles of risk management in a low neutral rate environment with compressed conventional policy space would argue for softening the expected path of policy when risks shift to the downside. 3 our review with recent indicators suggesting the expansion is continuing at a solid pace and unemployment at a 50 - year low, inflation has not yet moved to our goal on a sustained basis. in many ways, that can be viewed as an opportunity, with the sustained expansion providing critical job opportunities to a broader set of applicants. in parallel, it is also vital that a central bank meets its inflation target on a sustained basis, which will provide more capacity to buffer the economy if it encounters headwinds. 1 / 4 bis central bankers'speeches we are undertaking our review to ensure we are well positioned to meet our goals for many years to come, especially in light of the way the economy is changing, which i have been referring to as the “ new normal. " 4 there are a few key features of that new normal. first, interest rates have stayed very low in recent years in the united states and in many other advanced economies, and it seems likely that equilibrium interest rates will remain low in the future. low interest rates present a challenge for traditional monetary policy in recessions. in the past, the federal reserve has typically cut interest rates 4 to 5 percentage points in order to support household spending and business investment. however, when equilibrium interest rates are low, we have less room to cut interest rates and less room to buffer the economy using our conventional tool. another big change in the economy is that inflation does not move as much with economic activity and employment as it has in the past, which is what economists mean when they say the phillips curve is very flat. a flat phillips curve has important advantages : the labor market can strengthen a lot and pull many workers who may have been sidelined back into productive employment without an acceleration in inflation, unlike what we saw in the 1960s and 1970s. on the other hand, today ’ s low sensitivity of inflation to slack, along with the limited ability to cut interest rates in a recession, means it can be more difficult to achieve our 2 percent inflation objective on a sustainable basis. the limited ability to cut interest rates could provide less ability to buffer the economy in a downturn, while the very flat phillips curve could make it harder to boost inflation during an expansion. and that could further compress