As we move to refine and implement the Basel II framework for credit and operational risk, we need to strengthen the framework for market risk and encourage further improvements in how firms capture the possibility of extreme events.

More rigorous and comprehensive stress testing of large shocks across multiple markets, geographic regions and business lines is vital, particularly for systemically important institutions...Stress regimes need to take into account the effects of a firm’s own actions and trading strategies on market prices during times of stress, and the constraints on their room for maneuver imposed by size.

Among the major non-bank financial institutions, the most important part of the financial system today where we need a stronger capital regime relates to the CSEs [Consolidated Supervised Entities]. Even with the improvements in risk management at these institutions over the last few years, we are some distance from the point where their regulatory capital requirements appropriately reflect their risk.

The current regulatory treatment of market risk does a good job of capturing directional risk from movements in interest rates, exchange rates and equity and commodity prices. It is less effective, however, in capturing the full range of risks associated with some newer products and trading strategies, where values can react sharply and discontinuously.

Market participants should understand the nature of the chances they are taking. Markets price best if they take account not only of the most likely outcome but also of the risks of alternative developments.

As Chairman Greenspan has explained, monetary policymaking is risk management. The case for gradualism rests on the assessment that the cost of taking too large of an action is larger thn the cost of taking too small of an action. However, the story does not end here. While it is true that moving in a gradual manner reduces the chances of overshooting with all its attendant costs, the policymaker cannot afford to be consistently behind the curve. Given that monetary policy affects the economy with long and variable lags, there is a chance that by acting in this attentuated fashion we will undershoot the optimal policy stance. This can be at least as costly as overshooting. Our challenge is to weigh these costs and respond appropriately to the data and attendant risks involved. Our experience during the most recent business cycle underscores the need to be flexible in choosing the speed with which we respond to unfolding economic developments.

As in the past, without strong risk management and credit discipline, the prolonged period of favorable conditions could breed behavior by lenders that will contribute to a more severe credit cycle the next time around.

I don't see any reason why one would expect more excessive risk-taking with lower real interest rates. I don't see any sign of excessive risk-taking.

I personally don't have the sense that there is excessive risk-taking in US financial markets.

It is important that the world’s major private financial institutions run themselves with a sufficiently strong financial cushion, a cushion calibrated not just against the risks they confront in this uncertain world, but to the much more central role they play in many markets. Particularly for those institutions whose size and scope make them systemically important, capital, liquidity, and the overall risk management and control architecture need to be exceptionally strong.

Preparation for a potential problem seems to be the best course of action. Prudential supervision and good risk management in banking, and the pursuit of fiscal prudence and price stability during booms, may ultimately serve as the best insurance for dealing with the inevitable occasional asset-price breaks observed in our modern economy.

Central bank[s] must incorporate into [their] decisions the risks and consequences of several alternative outcomes. That is, [they need] to assess not only the most likely outcome for a particular course of action but also the probability of the unusual--the tail event. And [they need] to weigh the welfare costs of the possible occurrence of those tail events. This risk-management approach has been articulated by Chairman Greenspan for monetary policy, and it is equally applicable to a central bank’s decisions regarding crisis management.

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.

The belief in a government bailout if things go wrong creates an incentive for a company to take on risk and enjoy the associated increase in return...Although there is no way to eliminate the underlying risk, it is possible to reduce it by ensuring that the housing GSEs are overseen by an effective regulator.

While technology has quickened production adjustments, human nature remains unaltered. We respond to a heightened pace of change and its associated uncertainty in the same way we always have. We withdraw from action, postpone decisions, and generally hunker down until a renewed, more comprehensible basis for acting emerges. In its extreme manifestation, many economic decisionmakers not only become risk averse but attempt to disengage from all risk...But even when decisionmakers are only somewhat more risk averse, a process of retrenchment can occur. Thus, although prospective long-term returns on new high-tech investment may change little, increased uncertainty can induce a higher discount of those returns and, hence, a reduced willingness to commit liquid resources to illiquid fixed investments.