over a transition period. ultimately, the institution could be sold in whole or in part. but even in such cases the expectation of owners, managers, and uninsured creditors should be that real and significant losses will be incurred. in my judgment, if policies consistent with these principles are followed, then we will have eliminated much of the moral hazard associated with the federal safety net for depository institutions while simultaneously being able to achieve our goal of preserving financial stability. one way to enhance the ability of market participants to limit risk taking by banks might be to require at least the largest and most complex banks to issue a minimum amount of subordinated debt. many such proposals have surfaced over the last decade, including some from within the federal reserve system. and while i think that it is premature to endorse any one proposal, indeed there are a number of thorny details that would need to be worked out, i am strongly attracted to the basic concept advanced by proponents of subordinated debt. the fundamental notion behind requiring at least some banks to issue traded subordinated debt is to create a set of uninsured bank creditors whose risk preferences are similar to those of bank supervisors. because subordinated debt holders have downside risk, but virtually no upside potential, subordinated debt holders tend to be risk averse in much the same way as is the fdic. thus, when a bank sought to issue subordinated debt the price that investors were willing to pay would bring direct market discipline aimed at controlling excessive risk taking by the bank. a second key objective is to create a set of market instruments that would provide clear, and frequent, signals of the market ’ s evaluation of a bank ’ s financial condition. such signals could act as a deterrent to a bank ’ s tendency to take excessive risk, and could perhaps alert bank supervisors to examine, or otherwise intervene in, a bank more quickly than they otherwise would. changes in the market prices of traded bank subordinated debt, and perhaps other actions by the owners of this debt, have the potential to provide such signals. in this way subordinated debt could be used to bring indirect market discipline on a bank. supervisory discipline must be an effective and dynamic second line of defense while market discipline must be our first line of defense for ensuring financial stability, bank supervision also has an important role to play. the very nature of a systemic disruption, which imposes costs on not only the perpetrators, but also on many and diverse economic agents far removed from the immediate event

surprisingly, some banks have devoted substantial resources to attempting to achieve both adjustments to their portfolios. the resulting “ regulatory arbitrage ” surely causes some serious problems. for one thing, it makes reported capital ratios – a key measure of bank soundness used by supervisors and investors – less meaningful for government supervisors and private analysts. efforts are currently under way to redress many of the deficiencies in the current basle accord. but many of the issues are complex, and the optimal changes are still unclear. a consensus does seem to have developed that the accord must be more risk sensitive. but how risk sensitive, and how should that risk sensitivity best be implemented? i foresee a multistaged process with perhaps some modest and relatively noncontroversial “ fixes ” being proposed, possibly in the very near future, and more fundamental reforms being developed and implemented over a period of several years. given the dynamic nature of change in the financial sector, such a phased, or evolutionary, approach to revising the accord is probably not just the only practical strategy, but also the most prudent as well. the need for an evolutionary approach can be made with perhaps even more force to other supervisory policies and procedures. for example, the increasing use and sophistication of credit risk models at the largest and most complex domestic and foreign banks has profound implications for supervisory activities as well as capital regulation. understanding and evaluating credit risk models and related risk measurement techniques are quickly becoming required skills of bank supervisors. this need is fueled by the ever - growing array of securitizations, credit derivatives, remote originations, financial guarantees, and a seemingly endless stream of other financial innovations. add to this the fantastic speed with which financial transactions can now be conducted, and one begins to get a feel for the many challenges facing bank supervisors. with these realities in mind, supervisory practices at all of the banking agencies are changing. oversight of banks has become much more continuous and risk - focused than even a few years ago, especially at the largest and most complex organizations. it is recognized that we can no longer rely on periodic on - site examinations to ensure that these large institutions are operating in a safe and sound manner, but rather must be assured that their risk management practices and internal controls are sound on an ongoing basis. still, on - site examinations, in my judgment, remain critical. however, on - site examinations must evolve to be both as effective and as unobtrusive as possible. we