up, as all participants, wary of the unknown exposures of all others to the leveraged risk - takers, pull back. but this maintenance of liquidity and the smooth functioning of markets has become central to financial stability because even as regulated institutions have become more sound, they and other participants have come to rely more on markets for their own risk management. hence dislocation can have serious consequences. i am sceptical, incidentally, of the argument that hedge funds and the like necessarily add to liquidity. liquidity means being able to change a position without affecting the price, and depends on someone being prepared to make a price. hedge fund activity adds turnover, which probably means that in good times there is more incentive for price makers. but under conditions of pressure, leveraged investors are more likely to need to use the liquidity of the market than to be able to contribute to it. on such occasions – which is when liquidity is needed most – these funds surely are liquidity takers, not providers. additionally, there is, as tim acknowledges quite clearly, an inherent conflict over certain time horizons between market discipline and competition for business. precisely because hedge funds et al do add to turnover, they have considerable business to direct to financial intermediaries. when the money is flowing into the big funds, and returns have been high, they are more likely to be able to dictate the terms on which the various banks, investment banks, prime brokers and so on can get a share of that business. at those times, market discipline is likely to be eroded. in fact, this raises much broader issues of risk perception and management than hedge funds per se, and here tim makes some very good points. in particular, the emphasis on tail events, and on the uncertainty which surrounds estimates of potential losses, is very well targeted. risk management techniques need to extend beyond calculations of vars and the like – as complex as such calculations already are – and to think about whether the possible size of losses associated with the one - in - a hundred event really are well described by standard distributions drawn from recent history. they need also to contemplate the possibility that the correlations between portfolios will in the future be different from those in history. this point takes on more importance, in my judgement, against the backdrop of the remarkably benign environment of the past decade in many countries. as tim notes, a succession of financial events have been absorbed by capital markets with apparent e

have insufficient market risks to be affected by the new guidelines or are branches, covered by their home country supervisors. our assessment remains that the new arrangements will not add materially to required capital for the banking system as a whole. however, the impact on individual capital ratios will vary, depending on the scope of each bank ’ s trading activities. for some there will be an increase. for others, required capital may actually fall, as the benefits from substituting specific market risk charges for existing credit risk capital will outweigh the additional capital needed for general market risks. the next question about supervision of banks ’ capital is whether the present rules covering credit risk might be replaced by a more sophisticated methodology more in line with the market risk framework. the current rules are relatively crude, in the sense that capital ratios are applied against very broad categories of credit exposure without any firm basis in the actual likelihood of loss. in the way that potential losses from a portfolio of traded instruments can be estimated using historical data on daily price movements, potential losses from a portfolio of loans can, in principle, be estimated from an examination of default histories. supervisors would add a mark - up for safety to these estimates, as they have in the case of market risk. lack of reliable data on defaults and credit losses has been a major obstacle to this approach. but banks are working to remedy this, and are making progress toward putting the management of credit risk onto a more objective / scientific basis. modelling techniques can be applied more easily to some components of a loan portfolio - - such as high - volume, standard housing and credit card receivables - - than to others. for this reason, an incremental approach to recognising models for credit risk supervision is likely to emerge. - 4there is probably quite a way to go before credit risk is generally as amenable to modelling as market risk is. and since credit risk remains potentially the greatest threat to the soundness of banks and banking systems, supervisors are likely to be conservative about changes to the present rules, with all their imperfections. implications of new government policies there is clearly a lot of market - driven change “ in the pipeline ” for banks. the government ’ s policy decisions following the financial system inquiry will further alter the environment for banks and others in coming years. those policy changes, announced by the treasurer early this month, have many dimensions. i would like to talk about just two of those - - effects on competition in banking and on