ben s bernanke : global imbalances – links to economic and financial stability speech by mr ben s bernanke, chairman of the board of governors of the federal reserve system, at the banque de france financial stability review launch event, paris, 18 february 2011. * * * by facilitating the allocation of the world ’ s savings to the most productive uses, the free flow of capital across national borders confers substantial economic benefits, including the promotion of economic growth. that said, we have seen a number of episodes in which international capital flows have brought with them challenges for macroeconomic adjustment, financial stability, or both. such challenges have tended to arise in two situations : first, when the “ rules of the game ” of the international monetary system – the policy responses that countries are expected to take to help foster a balanced global economy over time – are either poorly articulated or not observed by key countries ; and second, when the financial systems of nations receiving strong capital inflows have not been up to the task of investing those inflows productively. these issues are hardly new. in the late 1920s and early 1930s, the u. s. dollar and french franc were undervalued, with the result that both countries experienced current account surpluses and strong capital inflows. under the unwritten but long - standing rules of the gold standard, those two countries would have been expected to allow the inflows to feed through to domestic money supplies and prices, leading to real appreciations of their currencies and, with time, to a narrowing of their external surpluses. instead, the two nations sterilized the effects of these capital inflows on their money supplies, so that their currencies remained persistently undervalued. under the constraints imposed by the gold standard, these policies in turn increased deflationary pressures and banking - sector strains in deficit countries such as germany, which were losing gold and foreign deposits. ultimately, the unwillingness of the united states and france to conduct their domestic policies by the rules of the game, together with structural vulnerabilities in financial systems and in the gold standard itself, helped destabilize the global economic and financial system and bring on the great depression. the asian financial crisis of the late 1990s illustrates a somewhat different type of risk associated with large cross - border flows of capital. during the 1990s, strong capital inflows helped support robust growth in many asian economies. but thailand ’

##quities of many other industries, and one conventional explanation for this is that banks are quite opaque. it has become increasingly clear that investors cannot easily know the level of risk they are acquiring with any particular bank equity position. when it comes to assessing share values, uncertainty can often breed doubt : it seems reasonable to expect, as a long - run proposition, that more - accurate market valuations of bank equities will follow better disclosure. the three pillars discussed in the basel consultative documents flow directly from this multifaceted view, and the rank - ordering of their importance in the long run is not indicated by the number of pages devoted to each in the consultative documents. in the long run, the supervision pillar remains critical, but the supervision must be even more risk - focused and increasingly concerned with validating systems. line supervisors will evaluate the quality of risk management and examine the adequacy of the risk measures. without good supervision, the other pillars cannot stand. for example, accurate internal risk - based ( irb ) inputs are surely crucial to obtaining reasonably accurate regulatory measures of capital adequacy. and the market will not believe or use risk disclosures unless it believes that the underlying risk measures, like ratings and the probabilities of default, have been validated. thus, supervisors must validate the risk measures to support both capital regulation and market discipline. market discipline will become increasingly important. given informative and comparable disclosures of internal risk measures, the market will react more quickly and appropriately than any regulator to variations in risk postures, and such responses will help banks strike the right balance between risk and reward. formal capital regulation is the most familiar of the three pillars, and the one to which the most pages are devoted – no doubt because it, by definition, contains more “ rules ” that must be explained. capital ratios will serve as a trigger for corrective actions for banks that get into trouble. projecting ahead many years, better risk management may mean that troubled banks will be far fewer than they have been historically. ideally, the three pillars will work in an integrated way to strengthen banking systems. nonetheless, during the transition to a working basel ii, we may have to lean on capital regulation more than we hope to in the long run. in navigating that transition, our overarching goal should be to advance the practice of risk management and encourage its wider adoption. and we all should accept that a lot of work remains both for banks and for supervisors.