relies on effective supervision. this is a key aspect of the prevention of financial instability. financial stability oversight must also look at the system as a whole. so it is involved with the oversight of concentrations and of risk correlations, interrelationships and interdependencies. there is a premium on understanding channels of risk transfer and likely behaviour in response to shocks. this is what enables an appropriate policy response. real effort is needed to try to understand the dynamics of collective, and sometimes irrational behaviour of firms, their clients and counterparties - particularly behaviour that could lead to one - way markets. in a downward market they can be the scourge of stability and destroyer of liquidity. 3. financial stability and public policy the business of oversight of, and possible intervention in, the financial system falls to public authorities. the justification for this involvement is accepted by all but the freest of free marketers. raymond goldsmith, comment on hyman minsky ’ s “ the financial instability hypothesis : capital processes and the behaviour of the economy ” in c p kindleberger and j - p laffargue eds, financial crises : theory, history and politics. cambridge university press ( 1982 ). financial stability can be looked on as a public good. and the costs to society of crises and instability can go well beyond the cost borne by players within the financial services arena itself. not only is it important in providing an effective monetary transmission mechanism, but collapse and instability can lead to decline in aggregate demand and a rise in unemployment. research suggests that the average cumulative output loss of a banking crisis in an emerging market economy is nearly 14 % of gdp, and up to 25 % in developed countries. 2 the roles and aims of the public authorities - a combination of supervisors, central banks and government - embrace two interdependent fields. first there is the process of oversight itself - spotting risk concentrations and threats that could cause instability : and taking actions to mitigate these threats in a variety of ways. second, however, there is as a last resort the mechanism for intervention : if things go wrong and crisis is threatened or actually occurs. and things will go wrong. a zero - risk environment would not only be impossible, but would be undesirable. the moral hazard which would ensue, together with unwelcome restriction of market processes could ultimately add to, rather than detract from, social cost. we need to be in a position to decide about, and where

laurence h meyer : the new basel accord : challenges for banks and their supervisors remarks by mr laurence h meyer, member of the board of governors of the us federal reserve system, at the risk management association ’ s conference on capital management, washington, dc, 17 may 2001. * * * it is a particular pleasure for me to join you this morning. the risk management association has been a significant source of expertise and insight for the banking agencies. the rma ’ s comments on regulatory and supervisory proposals have uniformly been well thought out and responsible. your meetings with staff and your cooperation on special surveys to help flesh out proposals have been exemplary, if not essential, especially on recent efforts to modify the basel capital accord. i should, of course, stop heaping praise on the rma lest its bank membership begin to believe that the organization shares the blame with us for any regulation or proposal that is not to their liking. nonetheless, thank you for your help, and i know we can continue to rely on you for both candor and empirical insights, insights along the lines of your conference theme : the enterprise perspective on risk management. i suspect that the recently proposed changes to the basel accord will affect your working lives rather dramatically. the proposals touch upon many aspects of banking and many different kinds of risk, but much of the focus is on credit risk, and rma ’ s roots are firmly in credit risk. many of you will be key players in your organization ’ s response to, and comments on, the new accord – basel ii. as background to your efforts, i would like to review how we got where we are today and offer some views of the way forward. basel ii is a response to changes flowing from the increasing sophistication of risk measurement and management, but the shaping of the response has motivations that have become more multifaceted over time. it is fair to say that the supervisory community initially was motivated to move toward basel ii by the erosion of the basel i rules through capital arbitrage. simply put, “ capital arbitrage ” refers to strategies that reduce a bank ’ s regulatory capital requirements without a commensurate reduction in the bank ’ s risk exposure. one example of such arbitrage is the sale or other shift off of the balance sheet of assets with economic capital allocations below regulatory capital requirements and the retention of those for which regulatory requirements are less than the economic capital burden. aggregate regulatory capital thus ends up being lower than the economic risks