some of the advances in credit risk measurement and management in the industry. i am not going to be more specific at this point. here too the federal reserve has been actively engaged in analyzing the emerging tensions between bank practices and regulatory rules and has been working toward recommendations for reform. as you know, regulatory capital standards, at least those that apply to internationally active banks, require international consensus. the basle committee on banking supervision, under the leadership of william mcdonough, president of the federal reserve bank of new york, is moving toward active discussion of reform of the basle accord and the federal reserve will be an important contributor to this deliberation. without laying out the specifics of a reform effort, the direction must be to ensure that regulatory capital charges, especially those related to the banking book, better match economic risks. the federal reserve board ’ s website ( federalreserve. gov ) has several excellent staff papers on these issues that i call to your attention. today the same capital charge is assessed against a loan to a aaa - rated company as to a loan to a junk - rated company. as a result, banks tend to have very similar regulatory capital ratios despite the fact that they have quite different risk profiles. fortunately, the largest and most sophisticated banks can and do differentiate between their loans for the purpose of assigning internal economic capital as part of credit risk management. regulators have to take advantage of the same improvements in credit risk measurement and management to achieve this improved matching of capital to underlying risks. the problem is that, at this point, there is a considerable diversity in the quality of such risk measurement and management across banks and some serious limitations to the robustness of internal risk measurement models. so we need to encourage both continued advances in risk measurement and management and convergence toward best practice within the industry, at least for the largest, most complex and internationally active banks. the fact is, we may not yet be where we need to be in terms of credit risk measurement and management to implement a new capital standard that effectively resolves problems associated with regulatory capital arbitrage. so as we move toward a reform of international capital standards that harnesses the risk measurement improvements in banking, we need parallel efforts in credit risk measurement and management within the banking industry. if we can match these two efforts, we will hopefully be able to achieve meaningful reform of our capital standards. this would hopefully allow us to eliminate or at least significantly reduce incentives for regulatory capital arbitrage, ensure that risk

have made regulatory standards less effective and supervision more challenging, that it may be simply impossible to adapt regulatory standards and supervisory practices fast enough to keep pace with market developments. of course, market discipline does not come easy to banking. we start by establishing a safety net for banks, including deposit insurance, access to a lender of last resort, and payment system guarantees. this immediately reduces the incentives of market participants to monitor the risk - taking of banks and, in turn, encourages excessive risk - taking by banks. we then put in place a regulatory and supervisory framework to counter these moral hazard incentives. and, when we are done, we complain about the absence of market discipline. i appreciate that this sounds just a bit contradictory. i could be more consistent and perhaps more appreciated at this institute if i urged the dismantling of the federal safety net and the full return to reliance on market discipline. but it is clear that society has made one of those irreversible choices and will not choose to eliminate deposit insurance, the discount window, a federal reserve payments system, or bank supervision and regulation. moreover, my reading of history suggests that, despite the strong indications of the success of market discipline, the cost of the associated financial market disturbances on real economic activity are too high for market discipline to be the sole regulator of banking. i understand opinions differ on this, just as they must when supervisors and regulators make judgments to act at specific times. but, what is worth understanding is that there is now general agreement that moral hazard is a significant problem, that the markets are increasingly complex making it more difficult for supervisors and regulators - and that supervision and regulation have significant costs and inefficiencies. as a result, we must begin to increase our reliance on market discipline both as a governor and as an indicator. when i talk about market discipline, some hear a call for a substitution of more market discipline for less regulation and supervision. listen more closely. my concern is that the task of regulation and supervision has become more challenging and we therefore have to increase the effectiveness of our overall regulatory and supervisory framework to keep pace. i am referring here to the increased size, breadth and geographic scope of banking and to its increased globalization and complexity. i want to achieve this increased effectiveness by enhancing market discipline, modifying our regulatory standards, and adapting supervisory practice. we also want an efficient regulatory framework, one that achieves its objectives at the lowest cost. where there are opportunities to achieve the same degree of stability through