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.

Good risk management is more than just having high-quality data and sophisticated quantitative tools. Control and oversight mechanisms are vital elements of assessing internal capital needs.

Basel II provides a means for regulators to rely more on banks' internal estimates of risks--but only if those estimates meet certain supervisory standards. Our expectation is that Basel II will also promote further enhancements to risk management. Accordingly, the Federal Reserve considers Basel II to be a worthwhile undertaking and we look forward to its implementation.

The Federal Reserve has important responsibilities for maintaining financial stability. That involves ensuring ex ante, that banks, for example, are managing their portfolios safely, that the clearing and settlement systems are well-designed and secure, that there are good arrangements in place for dealing with some kind of financial crisis, no matter what its source might be, and that, ex post, should there be a problem, that there be plenty of liquidity provided to the banking system and that the Fed would make sure that whatever problems arise be brought to some venue where they can be unwound and discussed and assistance be given.

It is important to remember that most adjustment of a market imbalance is well under way before the imbalance becomes widely identified as a problem. Individual prices, exchange rates, and interest rates, adjust incrementally in real time to restore balance. In contrast, administrative or policy actions that await clear evidence of imbalance are of necessity late.

Overall, the banking industry is healthy. However, some issues warrant the attention of bankers and their supervisors. One credit risk management issue that has been in the news quite a bit lately is home mortgage lending, particularly the surge in originations of nontraditional mortgages...Banks' risk management procedures must take into account the unique characteristics and credit risk profile of these novel types of loans, especially because our experience with them is quite limited.

Corporate governance is more than effective risk management.

Risk management itself is not a mature discipline...risk management systems simply have not been in existence long enough to generate reliable results on risk trends and assessments, and so the very newness of the profession itself can be considered a disadvantage.

Some significant disturbances in the past decade have challenged market participants’ and regulators’ understanding of risk and revealed weaknesses in risk-management tools and practices.

Since the fall of 1998, we have not seen the kind of widespread uncertainty about the health of major players in financial markets that has in the past tended to intensify and spread the economic effect of adverse events [such as, excesses of the stock market bubble, including not only the overvaluation of many stocks, but also the lapses in corporate governance.] In my view, two basic reasons account for this relatively favorable outcome. First, risks probably are in fact better diversified and better allocated to those who are prepared to absorb them or to those whose financial distress is less likely to have feed-through effects on the economy. Second, monetary policy in the United States responded very aggressively to incipient declines in activity and inflation that resulted from the emerging problems.

In our risk-management approach to monetary policy, we attempt to reduce the odds that our nation will experience damaging macroeconomic tail events, that is, asset price movements that are much more extreme than our usual experience. But our capabilities are limited; ultimately, we are working with only the overnight interest rate and we concentrate on the price level more generally, which may not always be compatible with the stability of the prices of particular assets. And, like you, we cannot reliably anticipate what will occur. All the more reason for both private parties and regulators to pay particular attention to possible sources of risk and stress over coming years.

[Federal banking agencies] have observed some easing of underwriting standards...Lenders are sometimes offering interest-only loans and are sometimes requiring very small down payments and limited documentation of a borrower's assets and income. They are also relying more on automated-valuation models and entering into more transactions with loan brokers and other third parties. Given this easing of standards, there is concern that portions of banks' home equity loan portfolios may be vulnerable to a rise in interest rates and a decline in home values...There is concern that not all banks fully recognize the embedded risks in some of their portfolios.

Overall, a more electronic payments system will benefit society and will help improve payments system efficiency...However, the payments industry will have to rely more heavily on key telecommunications networks and computing systems. Mitigating the risk associated with greater reliance on electronic processing is vital and should be a top priority for the payments industry.

The U.S. financial system seems less vulnerable to specific shocks and better able to absorb larger shocks than was true in the relatively recent past. At the same time, however, changes in the structure of the financial system and an increase in product complexity could make a crisis more difficult to manage and perhaps more damaging...While the probability of a major crisis induced by the financial failure of a major institution may be lower, the damage associated with such an event could be higher.

Although hedge funds help improve the efficiency of our system and may also contribute to greater stability over time by absorbing risks that other institutions would not absorb, they may also introduce some uncertainty into market dynamics in conditions of stress.