than inhibited. many steps are needed to make financial institutions and infrastructure more robust. for example, we need to strengthen bank capital requirements, improve liquidity buffers and make financial market infrastructures more resilient to shocks when individual firms get into trouble. in terms of capital requirements, many changes are needed, including global capital standards that put more emphasis on common equity, establish an overall leverage limit and better capture all of the sources of risk in the capital assessment process. improved risk capture, for example, includes the trading accounts of banks. some institutions had clearly not set aside adequate levels of capital given the risks that were embedded in their trading positions. it would also be very desirable to develop a mechanism to bolster the amount of common equity available to absorb losses in adverse economic environments. this might be done most efficiently by allowing the issuance of debt instruments that would automatically convert to common equity in stress environments, under certain pre - specified conditions. such “ contingent capital ” instruments might have proven very helpful had they been in place before and during this crisis. investors would have anticipated that common equity would be replenished automatically if a firm came under stress, and this knowledge might have tempered anxieties about counterparty risk. at a minimum, contingent capital instruments might have enabled common equity buffers at the weaker firms to be replenished earlier and automatically, thereby reducing uncertainty and the risk of failure. on the liquidity front, there are a host of initiatives underway. the basel committee on banking supervision is working on establishing international standards for liquidity requirements. there are two parts to this. the first is a requirement for a short - term liquidity buffer of sufficient size so that an institution that was shut out of the market for several weeks would still have sufficient liquidity to continue its operations unimpaired. the second is a liquidity standard that limits the degree of permissible maturity transformation – that is, the amount of short - term borrowing allowed to be used in the funding of long - term illiquid assets. under these standards, a firm ’ s holdings of illiquid long - term assets would need to be funded mainly by equity or long - term debt. with respect to financial market infrastructures, the federal reserve is working with a broad range of private - sector participants, including dealers, clearing banks and tri - party repo investors to dramatically reduce the structural instability of the tri - party repo system. similarly, over - the - counter ( otc )

than dampen their impact. for example, with respect to capital, firms under stress had incentives to continue to pay dividends to show that they were strong. these dividend payments actually depleted capital, making the firms weaker and vulnerable to credit rating downgrades. when credit ratings were indeed cut, that increased collateral calls, which intensified the pressure on scarce liquidity resources. regulatory gaps were another important factor in causing the crisis. american international group, inc. ( aig ) is a case in point. aig financial products, a subsidiary of the aig parent company, provided guarantees against default on complex collateralized debt obligations, leveraging the aaa rating of the aig parent company in the process. this activity was conducted with inadequate regulatory oversight, poor risk management and insufficient capital. finally, many of the incentives built into the system ultimately undermined its stability. the problems with incentives were evident in a number of areas, including faulty compensation schemes and risk management that was too narrowly focused on one business area without regard for the broader entity. these incentives created important externalities in which participants did not bear the full costs of their actions. turning to where we are now, the u. s. financial system is in much better shape today than it was a year ago. the capital markets are generally open for business – with the important exception of some securitization markets – and the major securities dealers that survived the crisis have seen a sharp recovery in profitability. the largest u. s. bank holding companies, which went through the supervisory capital assessment program exercise, have more and better quality capital, having raised more than $ 100 billion of common equity over the past year in the capital markets and generated nearly as much common equity via preferred stock conversions and from gains on asset sales. however, many smaller and medium - sized banks remain under significant pressure. this reflects several factors. first, such institutions hold assets that are carried mainly on the books on an accrual basis. compared with mark - to - market assets, such assets adjust much more slowly to changes in market conditions and the economic environment. second, many of these banks have a much more concentrated exposure to commercial real estate, a sector that remains under considerable pressure. not only have capitalization rates risen sharply – meaning the investors will pay much less for a dollar of rental income than before – but the rental income streams on these properties also have declined as the performance of the u. s. economy has declined. together, these two factors