effective manner. to illustrate, i ’ ll borrow a concept from the field of statistics. when drawing conclusions based on test results, statisticians and scientists often factor in the possibility of erroneous results, or “ false negatives ” and “ false positives. ” some economists have extended this concept to assessing the effectiveness of regulation. imagine that you visit your doctor for an annual checkup and have your cholesterol level tested. when the results come back from the lab, they show that all is well. but what if your cholesterol actually was high and an error in the test resulted in a clean bill of health? that would be a false negative, and i ’ m sure you can see the problems it would pose. you might not change your diet and exercise habits, and your doctor probably wouldn ’ t refer you for further testing or give you that firm lecture that they like to give about the importance of taking better care of yourself. instead, your rising cholesterol levels would go undetected and untreated until your next checkup, or even worse, until you suffer a heart attack. in the context of bank supervision, a false negative occurs when an examiner does not identify and address a deteriorating or failing bank in a timely manner. history has shown that the costs of these false negatives can balloon during times of broad economic and financial stress, which results in a significant drag on the economy and weakens banks ’ ability to lend. there were clearly too many of these false negatives in the recent crisis, particularly among the largest financial firms, both here and abroad. in addition to the billions of dollars of direct costs to the deposit insurance fund as a result of bank failures, the deep recession of 2007 to 2009 most likely would have been mitigated had the risk of exposure to real estate at many banks been recognized earlier. many of the reform efforts that regulators and the congress have undertaken – reforms that are clearly needed – are aimed at improving regulators ’ ability to identify and address troubled institutions earlier, and to limit the impact of failures when they do happen. now, returning to the medical analogy, imagine that your test results show that your cholesterol level is worryingly high, only in this case you are actually the picture of health. this is a false positive, and it poses problems of its own. while there may be some ancillary benefits to improving your diet and exercise habits, the inaccurate test result likely would cause you undue angst

to that end, the federal reserve and other federal regulators are devoting considerable time to implementing the requirements of the dodd - frank act. translating all of the new legislative requirements into rules and regulations, and then into an effective supervisory and examination program, is a massive undertaking, but it is essential to moving beyond the stabilization phase of crisis recovery and into that phase where we address the underlying fault lines in our financial institution landscape. as we work through dodd - frank implementation, we will need to ask : what constitutes effective supervision in the post - crisis world? i expect that the answer will be the subject of debate for months and possibly years. the process of identifying the factors most important to constructing an effective supervisory and examination program has already begun. for america ’ s community banks, the vast majority of which did not contribute to the subprime crisis, the contours of this program will be of critical importance. bis central bankers ’ speeches as we have learned all too well, a financial system dominated by a handful of large institutions is unlikely to be resilient in the face of a crisis. my view is that a diffuse financial system – one with a diverse range of institutions of varying size and complexity – is preferable to a system that is highly concentrated. in fact, the need for diversification is one of the great lessons of the crisis. indeed, we found that, irrespective of size, those banks most likely to weather the crisis were those with diverse loan portfolios, management information systems capable of monitoring concentrations, reasonably diversified funding sources and liquidity management processes, and forward - looking analyses that considered how loan portfolios might perform and affect bank conditions under periods of stress. we need many, many more banks with these characteristics because these are the banks that absorbed the shocks of the crisis, remained relatively healthy, and, most significantly, now have the potential to thrive as robust sources of credit in their communities after the crisis. as i see it, we need to create within the dodd - frank regulatory architecture a supervisory and examination program that encourages diversification and forward - looking strategies as a means to ensuring a healthy financial system and a steady flow of loans to creditworthy borrowers. am i saying that it is the responsibility of examiners, in essence, to guarantee that the banking system becomes more resilient and incapable of failure? no. a regulatory system that guarantees against bank failures is not in my mind desirable, even if such a system could be established in a cost -