not grow wider. indeed, an important function of supervisors is to act as something of a clearinghouse for best practices. if the supervisor perceives a deficiency in practice, it is his responsibility to engage the bank manager in a discussion as to whether the shortcoming really exists and, if so, how to fix it. i will conclude by reiterating the three points i made at the beginning. first, there is a strong and dynamic thread running between regulation and market innovation. while the basle accord of 1988 was entirely appropriate to its time and circumstances, it is now clearly in danger of becoming outmoded by the pace of financial innovation. conversely, the regulation has contributed to some market innovations that appear to be driven, if not solely, at least primarily by the need to engage in regulatory capital arbitrage. second, the reality of globalization must be accounted for in designing and implementing our regulatory and supervisory systems. especially among developed nations, we cannot afford a growing disparity in the quality of risk practices at our important institutions, nor a disparity in the quality of supervision of those institutions. as bankers like to say, the worst competitor is an uninformed competitor - - and that goes doubly for the competitor ’ s supervisor. third, given that financial markets are constantly evolving, this means that our regulatory framework must also continually evolve. the international capital standard has not changed in basic form for almost a decade - - it is still a ratio - based rule. while it may still be adequate for the vast bulk of banking institutions, it clearly is inadequate for the world ’ s most complex banks. for these institutions, high capital ratios do not necessarily equate with low insolvency probabilities. thus, the ratio - based standard is inefficient in achieving the supervisors ’ objective of limiting bank failure to acceptable levels. worse, it may be fostering other inefficiencies in the banking system, to the extent the capital standard encourages regulatory arbitrage that entails significant transaction costs. in the absence of any viable alternatives, it is my view that we should begin now to plan for a models - based successor to the accord. inevitably, this will take a tremendous effort, given the complexity of the subject and the differences across institutions and between countries. moreover, a models - based system of capital regulation would require a degree of cooperation among supervisors, quite apart from having similar written rules, that is unprecedented. but i believe the

at lower capital requirements than if the assets remained on the bank ’ s books. this is accomplished, for example, by having the conduit “ remotely originate ” credits, thus allowing the bank to circumvent recourse capital requirements that apply only to assets sold to the conduit. alternatively, the bank can provide indirect credit enhancement to the conduit by, for example, supplying backup lines of credit to the obligors that use the conduit to raise funds. to a significant degree, the growth in securitization and other forms of regulatory arbitrage has been spurred by the inadequacies of the international capital standard. this has occurred largely because, over the last decade, many of the larger banks have developed fairly sophisticated internal models for formally quantifying risk, including credit risk within the banking book. these models are used to calculate internal economic capital allocations for various sub - portfolios of the bank, and it is because these internal capital allocations often differ substantially from the 8 percent regulatory standard that the problems arise. in the typical case, the bank attempts to formally measure each major type of risk associated with a product or business line - - credit risk, market risk, and operating risk. in the credit risk arena, for example, risk is measured as the estimated shape of a loss probability distribution over a particular horizon, generally one year. economic, as opposed to regulatory, capital is then allocated against this loss distribution in an amount necessary to meet some corporate goal for insolvency probability. for example, several large banks allocate enough capital internally for credit risk so as to reduce to 0. 03 percent the probability that credit losses will exceed allocated capital. why is this 3 basis point standard chosen? because that is the historical average default probability, over a one - year horizon, for double - a rated corporate instruments. in other words, the banking firm wants to hold enough capital so that the chances of it becoming insolvent are low enough to win a double - a rating on the bank ’ s own liabilities. the problem is that, when these economic capital calculations are made, they result in a very wide range of internal capital allocations for individual positions or sub - portfolios - - as low as several basis points up to more than 30 percent of the carrying value of the risk position. when a group of loans is assigned an internal capital requirement that is very low compared with the 8 percent regulatory standard,