in a market economy let me first discuss the crucial role banks play in a market economy. while specific arrangements may vary from country to country reflecting differences in history, custom and culture, the basic principles are common to nearly all market economies. bringing savers and borrowers together as we all know, starting a business, expanding an existing business, or embarking on any other kind of creative or entrepreneurial enterprise, requires money - investment capital. therefore, any society ’ s long - term economic prospects are best served when households and businesses freely decide to save part of their current income. but the decision to save is not, in itself, sufficient to ensure economic growth and prosperity. some institutional mechanism must exist through which society ’ s savings can be collected and channeled into productive investments. moreover, because savers will naturally perceive risk in parting with their money, they must be induced to entrust their savings to that institution that can then put their capital to work in sound and productive ways. for this to happen, a class of financial institutions must exist that the public views as a safe and convenient outlet for its savings, where at least some fraction of those savings are maintained in the form of highly liquid assets, and assets by which payments for goods and services can be made quickly, easily and safely. the single dominant class of institution that has emerged to play this crucial role of intermediating between savers and borrowers is the commercial bank. in virtually all countries, banks function as the repository of a large fraction of society ’ s liquid savings and the entities through which payments are made. even in mature industrial societies with highly developed capital markets, the commercial banking system continues to be the most important single element of the financial system. transaction accounts - the means of intermediation the prominent position of banks in the financial systems of market economies around the world stems from their unique role as the issuers of transaction accounts. transaction accounts are bank liabilities that are immediately payable on demand at face value - “ at par ” - and that are readily transferable to third parties. because a depositor may transfer or convert into currency the balance of a transaction account on demand, such accounts are often referred to as “ demand deposits ”. owners of transaction accounts can withdraw deposited funds, write checks up to the full amount in the account, or transfer a portion or the full amount of the account to a third party. the liquidity, acceptability and transferability of these accounts induce savers to entrust their

first place. should an institution experience difficulties, capital serves as a buffer to absorb losses and reduce the risk of spillover from a problem institution to other financial institutions. the primary tool of capital regulation currently is the set of minimum ratios that were devised in 1988 by the basel committee on banking supervision. they were set forth in an agreement known as the basel accord, and were adopted, among other reasons, to address the slide in international capital levels that was occurring over the previous decade. the accord was clearly a milestone achievement for the first time, supervisors in g10 countries were able to use a common yardstick for assessing banks ’ capital adequacy. but the accord has a number of serious shortcomings. for example, it does not adequately differentiate among degrees of credit risk and, as a result, banks have had incentives to take on higher risk exposures within broad risk categories. banks have also tended to engage in transactions that lower capital requirements without reducing economic risk. in addition, it has proved difficult to incorporate into the accord ’ s simple risk - weighting scheme the innovations of the last decade in the way banks manage and mitigate risk. as market risk management techniques developed, we were able to incorporate a state - of - the - art, value - at - risk approach in a 1996 market risk amendment. still, as credit risk management techniques have advanced, and as the importance of operational risk management has increasingly been recognized, it has become apparent that the long run relevance and efficacy of the basel ratios as an indicator of capital adequacy has been eroded. supervisors have long known that analyzing simple capital ratios in isolation can lead to incorrect conclusions about the relative strengths of institutions. thus, we also have relied on a review of banks ’ capital plans and on market discipline to assess capital adequacy. in june of last year, the basel committee formalized the link between these elements when it released a consultative paper laying out our vision for a new, more refined capital adequacy framework. in addition to establishing minimum capital requirements, the proposed framework places increased emphasis on the supervisory review of capital adequacy and the role of market discipline. we refer to these elements - minimum standards, supervisory review and market discipline - as the “ three pillars ”. together these pillars mutually reinforce safety and soundness by aligning capital relative to risk and by encouraging prudent risk management. this evolution in the committee ’ s thinking about capital adequacy follows from much of