lending, margin loans, and overthe - counter ( otc ) derivatives. for example, the existing basel i rule only imposes capital requirements on one side of a repurchase agreement, even though counterparty credit risk is present on both sides. for these reasons, a large and complex bank operating under basel i can easily and significantly increase its credit risk, without increasing its regulatory capital. this brings me to my second point : the advanced approaches of basel ii are designed to substantially reduce the perverse incentive effects and opportunities for regulatory capital arbitrage present in basel i. in short, basel ii significantly increases the risk sensitivity of the capital rule. under the advanced approaches, capital requirements for an exposure will vary on the basis of a bank's actual risk experience. if a bank increases the credit risk of its portfolio, its regulatory capital requirements will also increase, and vice versa. the enhanced risk sensitivity of basel ii will thus ensure that banks have positive incentives for lending to more creditworthy counterparties, for lending on a collateralized basis, for increasing loan seniorities, and for holding a larger capital cushion for higher - risk exposures. basel ii also includes sophisticated methods to address capital - markets transactions. third, the basel ii regulatory capital framework has three pillars – minimum capital requirements, supervisory review of capital adequacy, and market discipline through disclosure – that build on the economic capital and other risk - management approaches of sophisticated banks and competing institutions. as a result, basel ii will be better able than the current system to adapt over time to innovations in banking and financial markets. the new framework should also establish a more coherent relationship between regulatory measures of capital adequacy and the day - to - day risk management conducted by banks. finally, i would argue that one of the key benefits of the basel ii process is that it has prompted banks to make substantial progress in developing much more sophisticated riskmeasurement and - management processes. for example, most international banks have adopted detailed rating systems for credit risk that assess both borrower and facility characteristics. that is, the banks assign one rating that reflects a borrower's overall creditworthiness, and another for each individual exposure that takes into account collateral, seniority, and other factors that affect how much a bank is likely to lose on that specific exposure if the borrower defaults. in addition, large banks are increasingly using common credit - risk measurement concepts, such as probability of default ( pd ), loss given

to revive the price discovery mechanism. first, they will likely need to collect more detailed data. in particular, investors will need to gather data more systematically to help them understand the nature and risks of the underlying assets and the structures of the instruments. second, investors will likely require enhanced systems to warehouse and model data related to these instruments to better understand their risk profile, especially under stress conditions. third, investors will likely need to ensure that they have the appropriate human capital expertise – that is, people – to interpret, understand, and act appropriately on the results of their modeling and analysis. the investment in data, modeling, and assessment will take time so there may be an extended period before normal price discovery will return in markets for some existing products. in turn, given the likely increase in the costs of producing and evaluating certain complex instruments, these actions and efforts may affect investors ’ risk - reward calculus by increasing required returns – or the " hurdle rates " – on these investments. creators and sellers may respond by reducing complexity, improving quality of underlying assets or increasing transparency and disclosure. in light of recent events, market innovation may result in new instruments that satisfy the needs of both buyers and sellers – instruments that, of course, should not just be accepted on their face but should be subject to proper due diligence. in the end, investors will decide for themselves whether acquiring the data and expertise necessary to participate in certain markets is worth the cost. as a result, it is likely that these markets and instruments will look different than they did prior to the recent market turmoil. let me close by highlighting the role of the federal reserve over the past several months as a backstop source of liquidity in interbank funding markets. as price discovery broke down in a variety of markets, financial institutions, as intermediaries and liquidity providers themselves in the affected markets, became protective of their liquid reserves and balance sheet capacity. as a result, overnight and term interbank funding markets have come under pressure. the federal reserve accordingly took a number of steps to try to alleviate these pressures. the fed ’ s initial action in early august was to increase liquidity in short - term money markets through larger open - market operations – the standard means by which it seeks to ensure that the federal funds rate is maintained at or close to the target rate set by the federal open market committee. this extra provision of liquidity helped bring the funds rate down to its target early in the day ; it also eased banks ’ concerns about