accounting standards and public disclosure - - complement these supervisory efforts by fostering healthy financial institutions and efficient capital markets. in the course of supervising financial institutions, the federal reserve has developed considerable familiarity with financial instruments, both derivative and non - derivative, that are characterized by a wide range of complexity and risk. we have learned that in supervising trading and derivatives activities it is the underlying characteristics of a financial instrument - - and how it contributes to the overall risk profile of the firm - - that are important, not the instrument ’ s name. two instruments that differ in name only may have entirely different treatment under existing legal and accounting frameworks, even though the economic risks ( including market, credit, liquidity, operational, and reputational risks ) they embody are identical. financial engineering can certainly create derivative instruments that combine risks in complex ways. but the same engineers can create cash instruments that appear simple and traditional, but may have greater risk than many instruments labeled “ derivative. ” indeed, placing financial instruments in regulatory or accounting pigeonholes without regard to their true risks and economic functions can create disincentives for prudent risk management. the federal reserve is increasingly emphasizing the need for institutions to manage the aggregate or portfolio risks of banking and de - emphasizing a focus on specific instruments. risk should be measured and managed comprehensively. that is, an institution should manage the dynamics of its portfolio rather than manage specific instruments. a focus on individual transactions can ignore the interaction of the specified instrument with other instruments. although portfolio theory is widely appreciated by bankers and regulators, putting its principles into practice in banking has not been easy. for example, past banking crises have, in part, reflected a failure by some institutions to recognize and limit concentrations of risk within their portfolios. the federal reserve is increasingly recognizing the need for supervisory and regulatory policies to be more “ incentive - compatible, ” in that they encourage sound risk management within an institution. furthermore, supervisory and regulatory policies are placing increasing emphasis on minimizing burden by using internal risk measurement systems, and by reinforcing supervisory objectives through market forces. we believe that market discipline - - supported by appropriate accounting standards and public disclosure - - complements our supervisory efforts by fostering strong financial institutions and efficient capital markets. we believe this approach is more constructive than rote adherence to rules and regulations that may not be consistent with the firm ’ s own risk management systems. consistent with these policies, the federal reserve and other banking supervisors have explored regulatory approaches that encourage more

significant effects over time on behaviour and the structure of the financial system. that assumes that lessons from this crisis endure. but, of course, the most pernicious forms of myopia surely come out of prolonged periods of apparent tranquillity in markets and the economy. that is when everyone gets suckered into believing the world is a safer place than it is, with elegant theories and eloquent practical stories for why the world has really changed. which ultimately tips us from tranquillity to disaster. one of this university ’ s greatest twentieth century thinkers taught us that what counts as an argument – not just as a good argument, but as an argument at all – is not always firmly grounded. the deepest problem during the years in which a grave crisis is brewed is that those who see the signs are marginalised or literally not heard. what on earth are we to do about that? part of the solution must lie in the design of policy institutions. one reform would ask a dedicated and expert group to identify risks to stability and give them powers to address those risks that threaten the system or are leaving it vulnerable ; and, vitally, to require them to stick at that task year in - year out, even when everyone else would otherwise be losing interest, taking stability for granted. as adair said this evening, that is precisely what is going on in the uk through the creation of the bank of england ’ s financial policy committee. the first members were announced yesterday. this is a big reform. rather undermining my strictures to adair on his use of “ radicalism ”, i ’ ve described it a number of times as revolutionary. the fpc ’ s success ( or otherwise ) will not depend solely on its own ability to identify risks. rather we must ensure that the debate about stability – the flame if you like – never dies. for that reason, our accountability to the treasury select committee can help greatly through the public debate and commentatory that our appearances will stimulate. bis central bankers ’ speeches