william j mcdonough : the foundation of financial stability speech by mr william j mcdonough, president and chief executive officer of the federal reserve bank of new york, before the 50th anniversary symposium of the bank of korea, held in seoul, on 8 july 2000. * * * it is a true honor to address you today on the occasion of the 50th anniversary of the bank of korea. i regret that i am unable to join you personally in your celebration. the past half - century has been one of tremendous challenges and outstanding achievements for korea, to which even a short list of developments testifies : national rebuilding after the devastations of the korean war, the economic miracle, democratization and the emergence of a modern, urbanized and well - educated population. indeed, given initial conditions, korea might be considered the biggest success story of the last 50 years. this record reflects the long korean history of resilience in the face of external threat, the hard work and energy of the korean people, and the adoption of new models in response to environmental change. the bank of korea has played a key role in korea ’ s economic success. in the early stages of development, the bank acted to facilitate the state - led growth model. the bank ’ s role evolved as the economy became more market - driven over time, and the amended bank of korea act further enhanced the independence of the central bank and enshrined price stability as the primary objective of monetary policy. the economic crisis that began in 1997 represents the latest national challenge. true to historic form, korea has responded decisively and vigorously to that challenge, with the bank of korea playing a critical role in the overall effort. a strong case can be made that, of all the countries affected by the broader crisis in the emerging markets, korea has gone furthest to repair the damage and institute underlying reforms to prevent future crises. that said, in korea and elsewhere, the recovery is not yet complete, and more remains to be done. the depth, breadth and rapidity of economic and technological developments of the last several years clearly underscore the increasingly international nature of policy challenges, and the dramatic transformation of the international financial landscape. the intensified integration of markets - reflecting the globalization of capital, production and labor - has increased the risk of contagion, making it virtually impossible for any country that wants to be part of the global trading system to insulate itself from external forces. the crisis and the recognition that we have entered a new

they are compensated on the upside. this extends the boom. incentives incentives may be very important in determining whether we have a system that is dampening rather than amplifying. i think bad outcomes are not just about bad luck, they are also about bad incentives. the problem with incentives may be due to faulty compensation schemes, poor risk management or the fact that participants do not bear the full costs of their actions. one problem that we had in the u. s. banking system over the past year was a reluctance of banks to raise sufficient capital to be able to withstand bad states of nature. they didn ’ t want to do this because this might unnecessarily dilute their shareholders. as a result, many banks did not hold sufficient capital and market participants knew this. this led to tighter financial and credit conditions, which made the bad state of the world more likely. this is an example of both bad incentives and an amplifying mechanism. the supervisory capital assessment program ( scap ) exercise that we undertook in the united states leaned against this. by forcing all the banks to have sufficient capital to withstand a stress environment, we increased the likelihood that all the big banks would be able to survive a stress environment. this generated an improvement in confidence and a willingness of banks to engage with each other. this also made it easier for banks to be able to tap the capital markets. the scap exercise made a bad state of the world outcome less likely, helping to create a virtuous circle rather than a vicious one. the scap exercise was conducted on an ad hoc basis. it probably would be much better to figure out how to do these types of exercises on a systematic basis. such exercises may need to be hardwired into the oversight of the financial system. capital requirements are one area where i think we could adjust the rules in a way to improve incentives. for example, imagine that we mandated that banks had to hold more capital, but that the added capital could be in the form of a debt instrument that only converted into equity if the share price fell dramatically. what would this do? it would change management ’ s incentives. not only would management focus on generating higher stock prices, but they would also worry about risks that could cause share prices to fall sharply, resulting in dilution of their share holdings. debt convertible into equity on the downside would also be helpful in that it would be a dampening mechanism – equity capital would be automatically replenished, but