In the United States we have as a first line of defense we have a risk weighted capital ratio which is not a straight leverage ratio, it's an amount of capital we have to hold against assets where we have to hold more capital against riskier assets, which makes sense. The risk of the asset, the more capital you want to hold and we are, we the Federal Reserve and the other bank regulators are working very actively with other regulators around the world to strengthen the capital requirements. We've already made proposals to do that. We are going to get assessments from the banks about how big an impact that would have. And it's our intention to move forward with more conservative higher capital requirements. So that's the first thing.

The leverage ratio is kind of a back stop, a fail safe if you will, because it's a very simple ratio, it's just a ratio of capital against total assets without making much or any distinction between Treasury's versus loans to small businesses for example. And the United States has long had a leverage ratio as a backstop to our capital rules.

One of the interesting things that appears to be coming out of the international negotiations is that the U.S. leverage ratio, which never was used abroad now looks like it will be adopted by other countries as well, which is good for us because it'll create a more even playing field and create greater safety in the global banking system as well as here.

So the leverage ratio is part of these negotiations and discussions we're having internationally and there are proposals on the table. We haven't yet gone through the whole process of doing the quantitative analysis to figure out exactly what the right number is, so I can't tell you off hand you know what the final number will be, but we're certainly looking to make the leverage ratio part of the more conservative approach to making sure that banks have enough capital that they can absorb even in a severe crisis like one we've had they can absorb their losses.
So yes, that will be part of our proposal.

In terms of the financial cushions, the challenge is to sustain a level of capital and liquidity that is large enough to withstand a more adverse financial and economic environment than we have experience recently. Here the job of the risk management discipline is to try to compensate for failure of imagination, to counteract the gravitational effect on measured exposure produced by recent history, and to try to anticipate the adverse effects on market liquidity that may come with a shock. This requires a healthy skepticism about models, discipline and care in the face of competitive pressures, and humility about what we can know about the future.

Capital is obviously an invaluable support for the safety and soundness of our banking system...Generally, economic models of capital are tied to unexpected losses. The assumption is that expected losses in the ordinary course of business should be covered by normal operating earnings. For losses beyond the normal range of expectations, sufficient capital should be in place to absorb the loss and leave the financial institution stable and able to continue operating effectively.

One of the questions regulators have been asked as we work toward implementing Basel II is whether we can just continue to encourage the improvement in risk modeling at banks and stop there, i.e., not tie risk models to capital. While improvements in the methodology of risk models and the transparency of better risk modeling in business decisionmaking are very useful, I believe we cannot stop there...For safety and soundness reasons, bank supervisors must be sure that a bank with greater exposure to riskier lines of business, products, and customers holds more capital than a bank that is more risk adverse and designs its business plan to minimize risk taking. That is, just looking at risk models and not tying capital to the measured risk exposures does not provide the backstop that supervisors need to ensure that each institution has the appropriate capital in place before the unexpected loss occurs. Capital should be based on risk exposures, and the evolving risk modeling methodologies provide improved tools to better determine the appropriate level of capital. 

In the past few years, the financial markets have come through an extraordinarily stressful period, but one that was not marked by the sort of financial-sector distress that accompanied and intensified the economic problems in many previous such episodes. I attribute that relatively good record, in no small part, to greater diversification of risk, to the growing sophistication of risk management techniques being applied at more and more institutions, and to stronger capital positions going into the period of stress.

Furthermore, joint distributions estimated over periods that do not include panics will underestimate correlations between asset returns during panics. Under these circumstances, fear and hence disengagement on the part of investors holding net long positions often lead to simultaneous declines in the values of private obligations, as investors no longer materially differentiate among degrees of risk and liquidity, and to increases in the values of riskless government securities. Consequently, the benefits of portfolio diversification will tend to be overestimated when the rare panic periods are not taken into account.

... At a minimum, risk managers need to stress test the assumptions underlying their models and consider portfolio dynamics under a variety of alternative scenarios. The outcome of this process may well be the recommendation to set aside somewhat higher contingency resources--reserves or capital--to cover the losses that will inevitably emerge from time to time when investors suffer a loss of confidence. These reserves will appear almost all the time to be a suboptimal use of capital, but so do fire insurance premiums--until there is a fire.