We judge the appropriate balance not against the standard of whether it reduces to zero the probability of a major financial crisis, the failure of a large individual financial institution or a major reduction in asset prices. That is not an appropriate objective of policy. Some vulnerability to crisis is a necessary and unavoidable feature of a dynamic and efficient financial system where asset prices need to be able to adjust to changes in fundamentals.

[A] broad range of recent financial shocks do not seem to have adversely impacted the real economy. The international financial crisis that began in 1997 did not spillover to the nonfinancial sector in the United States. The equity price collapse and deterioration in credit in 2000 did not cause significant damage to the core institutions in the U.S. market. The relatively limited damage caused by operations failures of the 9/11 attacks reflected the strength of the capital position of major intermediaries, as well as the policy actions by the Federal Reserve to provide liquidity to the markets.

More recently, the series of smaller financial shocks experienced since 2001, including the corporate bond defaults after 2001, the corporate accounting scandals in 2002, credit downgrades in the U.S. automobile industry in 2005, the failure of Refco, the sharp declines in mid-2006 in equity, commodity and emerging markets debt prices caused little contagion to other markets and limited strain on financial institutions.

Operational risk and infrastructure failures have played a prominent role in past financial crises, and the infrastructure weaknesses that have characterized the credit derivatives markets since their inception are another credible source of concern.

The Federal Reserve has been working with other regulatory agencies and the private sector both here and abroad to strengthen the financial system in order to lower the odds that a sharp change in prices or questions about a major market participant would lead to a systemic financial crisis. Our collective efforts have been in three areas: enhancing market discipline; encouraging sound risk management; and strengthening clearing and settlement systems.

Counterparty discipline, sound risk management, and strong and resilient clearing and settlement are all in the interest of private parties. Nonetheless, government has a role to play, especially when it senses moral hazard is weakening market discipline on risk taking and leaving the broader interests of society inadequately protected. Regulators may need to insist on minimal capital levels and on actions to strengthen private systems.

Experienced investors know, or should know, that in any given year some hedge funds lose money for their investors and some funds go out of business. Those occurrences are only normal and to be expected in a competitive market economy. The Working Group's recommendations were aimed, instead, at ensuring that when hedge funds fail, as some inevitably will, the effects will be manageable and the potential for adverse consequences to the broader financial system or to real economic activity will be limited.

Authorities cannot entirely eliminate systemic risk. To try to do so would likely stifle innovation without achieving the intended goal. However, authorities should (and will) try to ensure that the lapses in risk management of 1998 do not happen again.

By spreading risk more widely, by making it easier to purchase and sell protection against credit risk and to actively trade credit risk, and by facilitating the participation of a large and very diverse pool of non-bank financial institutions in the business of credit, these changes probably improve the overall efficiency and resiliency of financial markets.

While the risks to financial stability that arise from the creation of a small number of large and complex firms are obvious, there may be benefits as well. Greater concentration in financial services has the potential to have some positive impact on financial stability because lower costs can allow firms to build the capital reserves that help insulate them from shocks, and greater diversification can reduce firm risk.

The Federal Reserve Board endorsed the creation of a dormant bank, referred to as NewBank, which would be available for activation to clear and settle U.S. government securities. Such activation would occur if a credit or legal problem caused the market to lose confidence in an existing clearing bank and no well-qualified bank stepped forward to purchase that bank's clearing business.

My observation is that the significant deficiencies in mutual fund practices resulted from a combination of factors and a breakdown in controls. First, mutual fund activities were not being effectively overseen by their mutual fund boards. Second, there were strong financial incentives at certain firms to increase the profitability of mutual fund activities, but the legal and reputational risks of these incentives were not appropriately addressed. Third, a lack of adequate employee training resulted in employees deviating from standard procedures, in order to accommodate certain large customers.

The more critical role played by hedge funds and other nonbank financial institutions in credit and other markets has the potential to magnify the impact of distress in those institutions on market dynamics and liquidity if counterparty risks are not managed appropriately.

We are in a period of perceived strength in economic fundamentals in the United States and many countries around the world. This strength has helped to induce significant reductions in a range of market-based perceptions of risk. Much of this confidence may prove warranted and durable, but the extent to which it endures will depend in part on the degree to which those running the major financial institutions in the United States use the opportunity presented by this period of relatively high profitability to strengthen their capacity to withstand a less favorable overall macroeconomic and financial environment.

Private-market regulation can be effective for achieving the public policy goal of safety and soundness and broader financial stability. Government regulation and oversight should seek to provide an environment in which private regulation can be most effective. Government regulation should not place unnecessary barriers--domestically or internationally--in the path of the future evolution of private-market regulation. Innovation should be fostered, and regulatory protectionism should be rejected.

The occurrence of glitches in new markets and institutions need not reflect policy failures or provide evidence that an innovation is undesirable. Preventing all such occurrences would probably require us to stop all innovation. But neither is it desirable that growing pains in one market or at a few institutions spill over so strongly that the financial system as a whole could be destabilized.