bank. there is no " one size fits all " approach to risk management, which is still a partnership between science and art. supervisors look at the individual pieces and the way they fit together both for each of the institution's business lines and for the firm as a whole. supervisors also endeavor to look for outliers in the organization, particularly operations that appear to be outgrowing the original control structure. providing some illustrations of how supervisors view the key elements of the risk - management process may be instructive. the critical importance of the first fundamental element, active oversight by the board and senior management, has become quite clear recently. in past decades, the directors at times seemed content to concern themselves with only summary information regarding management's strategy and financial performance. in recent years, expectations for corporate governance have been raised, and the fallout from enron and other corporate mishaps have further intensified scrutiny in this area. recent difficulty in the accounting for special purpose entities ( spes ) is an example of an area where an active board can significantly help ensure that an institution understands, discloses, and manages risk appropriately. directors should be asking the following question : is management's accounting for material or its innovative transactions in sync with the substance of these transactions? for example, if assets are to be shed from the balance sheet by selling them to a special purpose entity, are both the risks and the rewards being transferred to a third party? if the answer is no, then a prudent director would require that the assets remain on the balance sheet ( such as in the case of a " nonqualifying " ( spe ), or that the accounting be supplemented with enough disclosure to inform investors of the ongoing risks these assets continue to present to the institution. recent experience also highlights the potential benefits of the board's audit committee meeting with external auditors without management and aggressively seeking assurances that risks associated with off - balance - sheet and special purpose entities are clearly represented. stimulated by recent events, a sea change is occurring and investors, creditors, ratings agencies, and regulators expect far more transparency than was expected even one year ago. the importance of the second fundamental element, adequate risk management policies and limits, is well illustrated by what supervisors are seeing in merchant banking activities. in particular, the volatile nature and difficult valuation issues confronted by risk managers of merchant banking operations call for more formal procedures. since the passage of the gramm - leach - bliley act in 1999,

fund its holdings of some security, borrows short - term from a money market mutual fund, while pledging a security of greater value as collateral. the excess of the value of the security over the amount borrowed at the time of the transaction is the “ haircut ”. haircuts protect the cash lender, since, if the borrower cannot repay, or chooses not to because collateral values have fallen, the lender can take and sell the collateral to satisfy its loan. the larger the haircut is at the time of the transaction, the greater the lender ’ s protection ; that is, the greater the likelihood that that the value of the security, when sold, will exceed the amount owed plus interest. presumably, lenders assess their borrowers ’ riskiness and calibrate the amount of the appropriate haircut. regulators should require them to do this consistently and prudently across the credit cycle. haircuts tend to be cyclical : falling in good times, which adds to the growth of credit, and rising in busts, which contracts credit. a regulator could mitigate the cyclical behavior of haircuts and its consequences by establishing minimum haircuts that apply in both good and bad times. calibrating minimum haircuts to the risks and volatility expected during bad times would make lenders more secure, increasing their resilience to losses. it could also make it more expensive to fund the purchase of the securities, and so could limit the amount of borrowing that could be supported by an asset of given value ; this, in turn, might limit creditfueled increases in the asset ’ s price. in other words, by requiring increased margin, the growth of credit can be slowed and resiliency can be strengthened. regulators can also simply require margin requirements to be increased in good times. this would lean against the growth of bubbles even if regulators had not yet discerned the particular type of asset bubble growing. underwriting restrictions the final class of policies that i ’ ll discuss involves underwriting restrictions that can directly address asset bubbles and their consequences. when assets like houses are largely financed with borrowed money, it is possible to use tighter underwriting requirements to lean against credit extension and growing leverage. this could be done, for example, through regulatory actions that raise lenders ’ minimum down payment requirements or reduce borrowers ’ maximum permissible debt - to - income ratios. such measures can be taken either on a one - time basis