difficult at any institution or set of institutions. it is even more difficult if the change is not consistent with the cultural and institutional environment and / or the skills of the management and staff. difficulty with staff expertise is why the first steps for effective risk management probably should be the least technical and the ones with the best chance for payoff in the short run. i am thinking of accountability, clear lines of authority and responsibility, and - to avoid conflicts of interest - the crucial separation of business line management from risk management and internal control. as i noted earlier, the latter alone could have saved barings. the next step, i suggest, is to begin thinking about returns in terms of the risk - return nexus, the raroc i noted earlier. just that simple way of thinking about an investment decision goes a long way in improving risk management. the best deal - especially for leveraged institutions like banks - is hardly ever the one with the best rate of return. rates of return are provided to compensate for risk. if rates of return are high, it is because they are compensating for a high level of risk. risk means variability, and leveraged institutions like banks have little tolerance for loss. that is why banking institutions must reduce and manage risk exposures, think of yields on a risk - adjusted basis, and realize that financial leverage can magnify the impact of losses as well as gains. a critical concern in developing a basic risk management process involves developing or attracting personnel with the skills necessary to apply risk management tools in meaningful ways. in the 18th and 19th centuries, bankers used to send their sons to work for competitors in financial centers in order to learn the latest techniques and then bring them home. some of that still goes on - although not so much for relatives any more - with time often spent at the organization ’ s own foreign branch or at a business school rather than at competitors. expertise was also transferred in the past by local branches of foreign banks training local residents. in the 21st century these are all still excellent ways to import skills in banking in general and risk management in particular. limiting foreign presence may be the worst thing for local banks - insulating them from competition and making the import of valuable human capital and expertise more costly. risk management implies significant limits on the ability of highly leveraged financial institutions such as banks to provide badly needed venture capital ; it implies that financial systems need more than banks. they need non - bank financial institutions that are less leveraged than

stock - price valuations at prevailing long - term interest rates could be justified by very strong earnings growth expectations. in fact, the long - term earnings projections of financial analysts have been marked up noticeably over the last year and seem to imply very high earnings growth and continued rising profit margins, at a time when such margins are already up appreciably from their depressed levels of five years ago. it could be argued that, although margins are the highest in a generation, they are still below those that prevailed in the 1960s. nonetheless, further increases in these margins would evidently require continued restraint on costs : labor compensation continuing to grow at its current pace and productivity growth picking up. neither, of course, can be ruled out. but we should keep in mind that, at these relatively low long - term interest rates, small changes in long - term earnings expectations could have outsized impacts on equity prices. caution also seems warranted by the narrow yield spreads that suggest perceptions of low risk, possibly unrealistically low risk. considerable optimism about the ability of businesses to sustain this current healthy financial condition seems, as i indicated earlier, to be influencing the setting of risk premiums, not just in the stock market but throughout the financial system. this optimistic attitude has become especially evident in quality spreads on high - yield corporate bonds - - what we used to call “ junk bonds. ” in addition, banks have continued to ease terms and standards on business loans, and margins on many of these loans are now quite thin. many banks are pulling back a little from consumer credit card lending as losses exceed expectations. nonetheless, some bank and nonbank lenders have been expanding aggressively into the home equity loan market and so - called “ subprime ” auto lending, although recent problems in the latter may already be introducing a sense of caution. why should the central bank be concerned about the possibility that financial markets may be overestimating returns or mispricing risk? it is not that we have a firm view that equity prices are necessarily excessive right now or risk spreads patently too low. our goal is to contribute as best we can to the highest possible growth of income and wealth over time, and we would be pleased if the favorable economic environment projected in markets actually comes to pass. rather, the fomc has to be sensitive to indications of even slowly building imbalances, whatever their source, that, by fostering the emergence of inflation pressures, would ultimately threaten healthy economic expansion. unfortunately, because