I do think, though, that there's been enough change in the financial system over the last two decades or so, that we have to be prepared occasionally - reassess whether we got the broad balance right. Whether this overall framework we have of supervision regulation where we have capital base supervision over a diminished and smaller share the system as a whole works in delivering the balance between efficiency and stability it's so important. That's a judgment that we've got to be prepared to look at over time. I don't think you can look at the balance today and say it's clearly wrong, it's clearly inadequate, but we may come to the point in the future that we're going to have to revisit that - both the scope and the design of that basic framework.

Supervisors need to continue to focus attention on reducing the vulnerability of the market to these low probability, but extreme events, while preserving the benefits that have come with these changes in financial markets. The limitations of the conventional risk-management tools in assessing potential losses in the adverse tail of possible outcomes in today’s financial system magnify the risk that individual institutions will operate with less of a cushion than might be desirable for the market as a whole.

As the central bank and the supervisor of banks, bank holding companies, and financial holding companies, the Federal Reserve is committed to ensuring that the Basel II framework delivers a strong and risk-sensitive base of capital.

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.

The recent Interagency Credit Risk Management Guidance for Home Equity Lending was not a regulatory effort to combat a housing price bubble, nor was it an example of regulatory suasion aimed at asset prices.  Rather, it was a response to indications that some banks were not appropriately managing risks in the home equity area.  The regulatory system is not designed to influence or control asset bubbles, but rather to ensure that bubbles, should they develop, do not lead to unsafe lending practices.  Although the guidance was not aimed at affecting asset prices directly, it may nevertheless affect market conditions through changes in the availability of credit for some riskier households.

Supervisors have been attentive to indications that home equity lending standards and risk-management practices may not have kept up with the very rapid growth in this form of lending. Last month, the federal banking agencies issued guidance to the industry that was aimed at reinforcing sound practices for lending and credit risk management. I encourage bankers to review that guidance and consider its recommendations carefully.

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.

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 banks} have all chosen implicitly, if not in a more overt fashion, to set our capital and other reserve standards for banks to guard against outcomes that exclude those once or twice in a century crises that threaten the stability of our domestic and international financial systems.

I do not believe any central bank explicitly makes this calculation. But we have chosen capital standards that by any stretch of the imagination cannot protect against all potential adverse loss outcomes. There is implicit in this exercise the admission that, in certain episodes, problems at commercial banks and other financial institutions, when their risk-management systems prove inadequate, will be handled by central banks. At the same time, society on the whole should require that we set this bar very high. Hundred-year floods come only once every hundred years. Financial institutions should expect to look to the central bank only in extremely rare situations.

I am obviously referring to far more adverse outcomes than I was alluding to in my earlier remarks on the need for private risk-management systems to adjust for crises in their estimates of risk distributions. However, where that dividing line rests is an issue that has not yet been addressed by the international banking community. Clearly, to choose the distribution of risk-bearing between private finance and government is to choose the degree of moral hazard. I believe we recognize and accept it. Indeed, making that choice may be the essence of central banking.

 At a conference honoring Anna Schwartz

The drive to stretch traditional underwriting criteria is intensifying. Recently, there has been a boom in so-called "subprime" lending, offering a variety of types of mortgage and other loans to borrowers who have less than good credit; such lending is priced for risk and the favorable pricing of securities backed by subprime loans have found acceptance with investors...

Improved access to credit for consumers, and especially these more recent developments, reflects a good news/bad news story. The good news is that market specialization, competition, and innovation have vastly expanded credit availability to virtually all income classes. Access to credit is essential to help families purchase homes, deal with emergencies, and obtain goods and services that have become staples of our daily lives. Home ownership is at an all-time high, and the number of home mortgage loans to low- and moderate-income families has risen at a rapid rate over the last 5 years. Credit cards and installment loans are available to the vast majority of households.

The bad news is that under certain circumstances this may not be entirely good news, either for consumers in general or for lower-income communities. Along with unprecedented credit access, some problems are occurring that should alert us all to potential dangers. While every potential problem doesn't result in disaster, it's important to recognize the risks and take protective steps.

Some loans to low- and moderate-income families with multiple underwriting flexibilities, layered subsidies, and high loan-to-value ratios have been showing unfavorable delinquency and default trends. Large mortgage lenders, secondary market agencies, and private mortgage insurers are conducting studies of their portfolios to determine how more-relaxed underwriting standards are affecting delinquencies and defaults. Although more study is required to determine which risk factors are most important in particular lending situations, the results of these portfolio studies bear watching.

Although legitimate lenders may be able to manage the risks associated with the overall expansion of lending, the same may not be true of many consumers, especially those with limited means to weather a storm or who have been encouraged to borrow improvidently. Should economic or personal difficulties occur, such as the temporary loss of a job, illness, or unexpected car or house repairs, those with limited incomes and without significant savings may easily find themselves in financial trouble.