basis, they also need to assess counterparties on a collective basis. they need to understand how their own actions to protect positions can put pressure on key counterparties, especially when other market participants are likely to be taking similar action to protect themselves. so beyond ensuring that their own individual positions are sound and well protected, banks need to assess whether there is a systematic component to a market that could adversely affect multiple counterparties at the same time, and thereby affect their own risk exposures. as we have seen, a counterparty does not need to be technically insolvent for it to be shunned by other market participants. the anticipation of downgrades, triggers, and so forth could very quickly cause a firm to lose funding and fail. in short, banks and regulators need to understand the type of market conditions that will exist when there is likely to be reliance on collateral, guarantees, or other contract clauses. it is then important to assess the likelihood that the bank's safeguarding actions could worsen market conditions and actually increase its losses. might the bank only realize collateral at substantially reduced prices? would multiple counterparties suffer distress at the same time? would guarantors perform in times of distress? in other words, would the collateral, guarantee, insurance, hedge, and so forth work in precisely the time the institution would need it most, that is, during a market stress event? these are important questions that regulators and supervisors are asking in the basel committee and in the financial stability forum, and i represent the federal reserve system on both of these bodies. naturally, these types of questions underscore the importance of stress testing and scenario analysis that focus on market - wide events. such stress tests would include the potential for key counterparties to fail or suffer difficulty at the same time, for market liquidity to erode and remain low for some time, and for market participants to view the bank itself as an impaired counterparty. and these stress tests, when properly designed, can provide information that typical statistical models may leave out or have trouble capturing, such as abnormally large jumps or market moves, evaporation of liquidity, prolonged periods of market distress, or structural changes in markets. stress tests are most useful when they aim to include potential secondary or " knock - on " effects, which are also often difficult to model with standard techniques. in these ways, stress tests can serve as a complementary tool to other risk measures. even if the ex ante estimate of

for banks to establish good risk management policies addressing the issues i have just discussed, so that strong risk discipline is codified. concluding thoughts of course, it is not just the banking industry, but also those of us in the public sector who have some key lessons to learn. banks and supervisors alike need to undertake additional work to facilitate the building of robust methods of quality assurance in the financial markets that will help to restore and maintain confidence. ensuring that banks exercise good risk management, of course, is an important job for bank supervisors, which includes overseeing their ability to properly capture the risks in the markets in which they operate, as well as their ability to conduct appropriate stress testing to explore potential consequences of different types of market distress. doing so requires that supervisors themselves develop a strong understanding of the value, limits, and potential harms associated with banks'attempts to protect their exposures. at the federal reserve, we have already begun to enhance our supervisory work in this area and are communicating expectations to banks. at the international level, we are working with our colleagues in other countries and within international bodies, such as the basel committee on banking supervision – which is meeting later this week – and the financial stability forum, to investigate whether other practices could be adopted around the world to mitigate the challenges i have outlined above. this work will be a major focus during the next few months and over the course of 2009. randall s. kroszner, 2008, " improving the infrastructure for non - agency mortgage - backed securities, " speech delivered at the federal reserve system conference on housing and mortgage markets, washington, d. c., december 4.