Basel II or something like it appears necessary. The banking system has become financially extraordinarily sophisticated. Basel I is no longer sufficient as a means of determining adequate regulatory capital for the banking system.

The Federal Reserve, the other banking regulators, international counter-parties have worked for a number of years trying to determine an appropriate system that would appropriately account for the complexity of the banking system. Basel II tries to embody the notion that the amount of regulatory capital should be based on modern risk- management techniques, which try to evaluate the risks associated with different kinds of investments.

[T]he actions of private parties to protect themselves--what Chairman Greenspan has called private regulation--are generally quite effective.

The Board [of Governors] is aware of the current and growing regulatory burden that is imposed on this nation’s banking organizations. Often this burden falls particularly hard on small institutions...The Board strongly supports the efforts of Congress to review periodically the federal banking laws to determine whether they can be streamlined without compromising the safety and soundness of banking organizations, consumer protections, or other important objectives that Congress has established for the financial system.

While some policies that carefully target truly abusive practices are warranted, the broader risk is of a regulatory overreaction that stifles much of the benefit of the technology-driven expansion in consumer credit.

Dramatic improvements in credit availability are accompanied by predictable increases in the incidence of delinquencies and abuse, as new products proliferate and new borrowers are drawn into the market. The spread of adverse outcomes inevitably triggers calls for new regulatory constraints on lenders. But while truly abusive practices certainly deserve regulatory attention, policy measures that impede the functioning of credit markets need to be approached cautiously to avoid an overreaction that stymies much of the benefit of the innovations in retail credit practices.

The effectiveness of financial market participation as an aid to household risk management can only be fairly assessed on an ex ante basis — that is, from the perspective of before the financial transaction has been initiated...

Popular discussions of lending practices often take a decidedly ex post perspective, revolving around the consequences of particularly bad outcomes. This amounts to policy by anecdote. An ex ante approach would ask instead whether a particular practice expands the menu of borrowing options in a way that is useful to households in pursuing their economic goals.

Some may see government regulation of OTC derivatives dealers as essential to ensuring efficacious risk management. This view presumes that government regulation can address the challenges these types of markets engender and that it can do so without lessening the effectiveness of market discipline supplied by counterparties. Market participants usually have strong incentives to monitor and control the risks they assume in choosing to deal with particular counterparties. In essence, prudential regulation is supplied by the market through counterparty evaluation and monitoring rather than by authorities. Such private prudential regulation can be impaired--indeed, even displaced--if some counterparties assume that government regulations obviate private prudence.

We regulators are often perceived as constraining excessive risk-taking more effectively than is demonstrably possible in practice. Except where market discipline is undermined by moral hazard, owing, for example, to federal guarantees of private debt, private regulation generally is far better at constraining excessive risk-taking than is government regulation.

The Federal Reserve has taken this process of employing new approaches to regulation a step further with its pre-commitment proposal. Pre-commitment allows banks to commit to the maximum loss they will experience over the next quarter in their trading portfolio; this commitment becomes their capital requirement. The proposal gives banks incentives to establish the commitment in a prudent fashion through fines and disclosures if it is violated. Economists in the audience will recognize this proposal as an application of an incentive-compatible approach to regulation.

I suspect that there are far more areas in our regulatory structure in which incentive-compatible approaches could be implemented.

To be sure, the effects of the banking crisis, as well as the ongoing pace of consolidation within the industry, have reduced the total number of banking organizations by more than a third since 1980...The new firms come into existence often to replace old firms that were not willing or able to take on the risks associated with high-growth strategies. This replacement of stagnating firms with dynamic new firms--what the economist Joseph Schumpeter called the "perennial gale of creative destruction"--is at the heart of our robust, growth-oriented economy. It is this freedom to take on risk that characterizes our economy and, by extension, our banking system. Legislation and regulation of banks, in turn, generally should not aim to curtail the predilection of businesses and their banks to take on risk--so long as the general safety and soundness of our banking system is maintained.

I think it would surprise most of you to learn that a time-and-motion study of the daily lives of Federal Reserve Governors would reveal that most of their efforts are devoted to bank regulatory issues, broadly defined. Most of this business is routine, extremely familiar, and intensely interesting to the banking industry, and totally unknown, deeply obscure, and generally quite boring to everybody else in society.

With any troubled financial institution, but especially in the case of large institutions, I believe discipline will be better served in a context in which the authorities maintain a policy of what I like to call "constructive ambiguity" as to what they will do, how they will do it, and when they will do it.  In saying this, I recognize that financial market particants do not like uncertainty, but that is just the point.  Moreover, while I fully understand the yearning in some quarters for the cookbook approach to problems in financial markets or institutions--large institutions especially--I regret to say that in my judgment such a cookbook does not and never will exist.