For example, credit derivatives, which are in a nascent stage of development, may someday lead to banks being able to trade credit risk associated with commercial bank loans as easily as they can alter the risk profile of their bond portfolios. Prior to these innovations, institutions could be generally compartmentalized into market segments that did not directly compete with one another. Government regulation mirrored and reinforced this segmentation. With financial innovation came new levels of competition, which then caused pressure for government to change the rules of play. As a result, the legal strictures preventing banks from engaging in certain businesses are being loosened.
Banks are increasingly in direct competition with securities firms and insurance companies.
New technology and financial innovation have clearly affected the way in which many firms manage their business. They have also put stress on many aspects of traditional legal, regulatory, and accounting frameworks. Over the past decade bank supervisors have learned some important lessons in this regard. Today, I would like to briefly summarize some of these lessons, illustrate how they are shaping the evolution of bank supervision, and some thoughts of how they may affect international supervision, as well. Perhaps the most basic lesson we have learned from our experience in supervising trading and derivatives activities is that the underlying risk of a financial instrument is more important than what an instrument is called.