financial stability implies that key institutions in the financial system are operating without significant difficulty and markets are generally functioning well. bankers implicitly accept risk as a consequence of providing services to customers and also take explicit risk positions that offer profitable returns relative to their risk appetites. the job of bank supervisors is to ensure that bank capital represents an adequate cushion against losses, especially during times of financial instability or stress. basel ii is yet another step to minimize the negative consequences of risk - taking by financial institutions, particularly those institutions that could contribute to financial instability. this is reflected in the use of unexpected loss to calibrate capital. the assumption is that normal volatility should be covered by normal operating earnings. for losses beyond the normal range of expectations, capital should be in place to absorb the loss and leave the financial institution stable and able to continue operating effectively. thus, financial institutions with weaker profit margins, or with customers with more varied ability to meet their obligations, should have more capital. it is important here to distinguish between higher expected losses, for which bankers raise prices to cover risk, and greater volatility of results, which requires additional capital. greater sensitivity of regulatory capital to risk has taken on increased significance as virtually all banking markets have become considerably more concentrated, with some companies - by their very size alone - posing the potential for systemic risk. also, the advanced approaches of basel ii better align regulatory capital to the risks presented by sophisticated financial instruments and to the complexity of large, internationally active financial institutions. the current basel i framework is more focused on credit risk for balance sheet assets. but sophisticated financial institutions carry fewer of their potential exposures on their books. rather, after credit - and market - risk mitigation, it is often the process of managing risks or laying off exposures that has created earnings surprises in recent years. basel ii is intended to mitigate potential disruptions in banking markets by improving risk measurement and management ; establishing a better link between risk and minimum capital ratios ; and providing more information to bankers, supervisors, and other market participants. but we should also remember that the increased sensitivity to risk in basel ii carries with it the possibility that minimum capital ratios could actually be more volatile than they are today. as my colleague bill rutledge pointed out yesterday, that is what we expect, since those ratios will be more responsive to changes in risk. the basel committee has attempted to reduce procyclicality effects in the new framework, incorporating factors such as estimates of loss se

##verities that focus on downturns. these are wise decisions intended to obviate the need for institutions to raise large amounts of capital at the trough of a downturn - something that can be quite difficult and add to financial market instability. but i think we could all agree that basel ii should not be unresponsive to changes in risk, for example when the obligor rating distribution at an institution shifts to poorer - quality borrowers. in my view, we want these signals of changes in risk reflected in regulatory capital levels. but by being careful about the extent that capital levels respond to cyclicality, we are trying to make sure that risk signals do not on their own generate added instability. this requires some balancing. greater responsiveness of regulatory capital ratios to risk is something that institutions will have to learn to manage under basel ii. given the potential for increased volatility in their capital ratios, i expect that institutions operating under basel ii will maintain a certain cushion above their minimum ratios since they must have the capital in place before the date of measurement of risk. indeed, pillar 2 of the basel framework ( supervisory review ) requires banks to develop a viable internal process for assessing capital adequacy that helps determine the amount of capital actually needed for their particular business mixes and risk profiles. explicit assumptions are built into pillar 1 ( minimum capital requirements ), such as the idea that portfolios are well - diversified and do not contain geographic or sectoral concentrations - assumptions that are not true in the case of many institutions. supervisors must remind institutions that it is initially the banks'job to address any deviations from pillar 1 assumptions, as well as any additional factors that affect the risk of the individual bank, and adjust their capital accordingly. under pillar 2, supervisory authorities, in turn, will review these adjustments by banks and could ask them to take additional steps to ensure that all risks have been addressed. there are additional reasons why i expect that well - run financial institutions will maintain capital ratios above the regulatory minimums, as they have under the existing basel i framework. some markets and customers will require their banks to have a stronger credit rating than that implied by the basel i or ii minimum capital frameworks. banks will also continue to be opportunistic in pursuing mergers and new business expansion, and this requires capital above the regulatory minimum to be able to respond promptly to new initiatives. finally, bankers who are using economic capital models such as raroc ( risk - adjusted return on