t measure credit risk although they represent a crude proxy for such risk within broad categories of banking assets. * finally, the capital standards give insufficient consideration to hedging or mitigating risk through the use of credit derivatives or effective portfolio diversification. these shortcomings of the regulatory capital standards were beginning to be understood even as they were being implemented, but no consistent, consensus technology existed at that time for invoking a more sophisticated standard than the basle norms. to be sure, more sophisticated standards were being used by bank supervisors, during the examination process, to determine the adequacy of capital at any individual institution. these supervisory determinations of capital adequacy on a bank - by - bank basis, reflected in the camel ratings given to banks and the bopec ratings given to bank holding companies, are much more inclusive than the basle standards. research shows that camel ratings are much better predictors of bank insolvency than “ risk - based ” capital ratios. but, a bank - by - bank supervision, of course, is not the same thing as the writing of regulations that apply to all banks. it is now evident that the simple regulatory capital standards that apply to all banks can be quite misleading. nominally high regulatory capital ratios - - even risk - based capital ratios that are 50 or 100 percent higher than the minimums - - are no longer indicators of bank soundness. meanwhile, however, some of our largest and most sophisticated banks have been getting ahead of the regulators and doing the two things one must do in order to properly manage risk and determine capital adequacy. first, they are statistically quantifying risk by estimating the shape of loss probability distributions associated with their risk positions. these quantitative measures of risk are calculated by asset type, by product line, and, in some cases, even down to the individual customer level. second, the more sophisticated banks are calculating economic capital, or “ risk capital, ” to be allocated to each asset, each line of business, and even to each customer, in order to determine risk - adjusted profitability of each type of bank activity. in making these risk capital allocations, banks are defining and meeting internal corporate standards for safety and soundness. for example, a banker might desire to achieve at least a single - a rating on his own corporate debt. he sees that, over history, single - a debt has a default probability of less than one - tenth of one percent over a

cannot simply be done by observing market indicators. for example, we cannot easily use the public ratings of holding company debt. the ratings, after all, are achieved given the existence of the safety net. the ratings are biased, therefore, from the perspective of achieving our stated goal - - to impose prudential limits on banks as if there were no net. in addition, i am sure that there would be disagreement between market participants and regulators over what should be acceptable debt ratings. the solution may be for the regulators to use the analytical tools developed by the market participants themselves for risk and performance assessment. regulators already have begun to move in this direction. for example, beginning in january 1998, qualifying large multinational banks will be able to use their internal value - at - risk models to help set capital requirements for the market risk inherent in their trading activities. the federal reserve is also conducting a pilot test of the pre - commitment approach to capital for market risk. in this approach, banks can choose their own capital allocations, but would be sanctioned heavily if cumulative trading losses during a quarter were to exceed their chosen capital allocations. these new and innovative methods for treating the age - old problem of capital adequacy are likely to be followed by an unending, evolutionary flow of improvements in the prudential supervisory process. as the industry makes technological advances in risk measurement, these advances will become imbedded in the supervisory process. for example, the banking agencies have announced programs to place an increased emphasis on banks ’ internal risk measurement and management processes within the assessment of overall management quality - - that is, how well a bank employs modern technology to manage risk will be reflected in the “ m ” portion of the bank ’ s camel rating. in a similar vein, now that var models are being used to assess regulatory capital for market risk, it is easy to envision that, down the road, banks ’ internal credit risk models and associated internal capital allocations will also be used to help set regulatory capital requirements. regulation and supervision, like industry practices themselves, are continually evolving processes. as supervisors, our goal must be to stay abreast of best practices, incorporate these practices into our own procedures where appropriate, and do so in a way that allows banks to remain sufficiently flexible and competitive. in conducting prudential regulation we should always remember that the optimal number of bank failures is not zero. indeed, “ market - based ” performance means that some institutions, either through poor management choices,