volatility. this change in market perception of future risk has occurred in the context, however, of a substantial increase in leverage in the balance sheets of the united states, the federal government and the u. s. household sector. these developments are a potential source of greater macroeconomic uncertainty. the second reason for greater attention to prudential concerns is that we are in the midst of substantial changes in the structure of the u. s. financial system. the largest financial institutions in our markets are substantially larger than even a decade ago in the scope and complexity of their operations and in terms of their importance in the markets in which they operate. hedge funds and other financial institutions that operate outside the scope of regulation or consolidated supervision now play a more important role in our financial markets. and we have seen a new way of financial innovation in credit risk transfer techniques and many new derivative instruments that have allowed risk to be measured and managed more effectively and distributed more broadly. these developments have contributed to what seems to be a significant improvement in the overall stability and resilience of the us financial system, by reducing the vulnerability of individual institutions to a broader range of potential shocks. they may also, however, add to uncertainty about how well the system might function in the context of a major systemic shock. and in this sense, they create some exacting challenges for risk management. let me focus on three areas where this is the case : counterparty risk management with respect to hedge funds and other unregulated entities ; risk management and market infrastructure issues in credit derivatives and other instruments ; and stress testing and scenario analysis. 1 / 3 first, the greater role of hedge funds and other unregulated entities in our financial system today requires more attention by the major banks and investment banks to counterparty risk management. the greater diversity of participants in risk intermediation is probably on balance a positive thing for our financial system. hedge funds, private equity funds and other kinds of investment vehicles help to disperse risk and add liquidity. their greater prominence in our markets, however, means that banks and investment banks face a heightened challenge in managing the risks involved in their exposure to these firms and in understanding the firms ’ ability to weather conditions of stress and their impact on market conditions in those circumstances. the degree of the systemic risk presented by the growth in the leveraged, unregulated financial institutions depends in part on how well the major dealers manage these challenges. market practice in these areas has improved significantly since 1998

policy accommodation given that inflation has fallen somewhat further below our objective. i would respond to these concerns by noting that monetary policy is still accommodative and that financial conditions have eased. in addition, the long and variable lags between monetary policy adjustments and their impact on the economy imply that the fomc may need to remove accommodation even when inflation is below its goal. in particular, if the unemployment rate were already below its longer - run natural rate, as may be the case currently, the impact on wage growth and price inflation would still likely take some time to become evident. this would be particularly true if inflation expectations were well - anchored at or slightly below our 2 percent objective, as is the case currently. on the other hand, some fed watchers have argued that we are helping to create financial asset bubbles by not removing accommodation more quickly. my view is that asset valuations are not particularly troublesome given the economic environment in which we ’ ve been — that is, a long period of moderate growth, low inflation, low interest rates, and low recession risks. i would be much more concerned about asset valuations if financial market performance were disconnected from the economy ’ s performance — for example, if market volatility were very low and asset valuations elevated at a time when the economy was performing poorly and the outlook was highly uncertain. stretched valuations would also be of greater concern if credit growth were unusually strong and financial institutions were becoming more leveraged and dependent on wholesale funding. the good news is that the substantially higher capital and liquidity requirements enacted in response to the financial crisis have helped to reduce the risks to financial stability. relatedly, some critics have argued that our asset purchases have unduly distorted financial asset prices. my response to this critique is that monetary policy — including large - scale asset purchase programs — works through its influence on financial conditions. we turned to asset purchases to provide additional monetary policy stimulus when the federal funds rate was constrained by the effective zero lower bound. in buying longer - maturity treasuries and agency mbs, we sought to reduce risk premia to provide additional support to economic growth at a time when the economy was operating far from full employment. the argument that monetary policy should avoid affecting asset prices — that it be somehow “ neutral ” — is not one that i find compelling. such an argument essentially implies that monetary policy should not be utilized to achieve the fed ’ s dual mandate objectives. another recent critique is that the fed has