One conclusion seems clear: prudent risk management by a critical mass of firms will not only help to ensure a safe and sound financial system, but also will reward individual institutions with longterm profitability. In my view, market discipline, enhanced by appropriate regulation and supervision, offers the only realistic path for us to achieve our goals of a strong and stable marketplace. Today, I would like to focus my comments on the importance of risk management techniques and how market discipline can be enhanced to the benefit of public and private sector participants alike. A series of market events over the past year and a half, beginning with the devaluation of the Thai baht in July 1997, had a major impact on many lenders and investors, revealing in the process several shortcomings in risk management techniques. One lesson financial institutions learned from these events was the need to continuously reassess both counterparty credit risk management techniques and assumptions about market liquidity. Broadly, financial institutions learned that reliable estimates of the size and portfolio composition of major counterparties were lacking and that improved credit risk management techniques were needed in two key areas: credit and market exposure measurement, and counterparty due diligence. Let me be a bit more specific about some of the weaknesses found in credit risk management techniques. For example, some institutions routinely performed credit assessments using sparse, often unaudited financial information from valued customers, some of which had recorded substantial profits in previous years.

The development of credit models by a number of banks has led to a deeper understanding and analysis of the relationship between risk and return in credit activities at the portfolio level. In addition, some banks are exploring the possibility of validating their internal ratings using information from the equities markets. BIS Review 8/1999  –4–  With respect to securities financing, several institutions have discussed and, in certain cases, already have implemented instrument specific collateral haircuts. Many institutions also have acted to ensure the adequacy of their current collateral holdings and developed procedures for accessing additional collateral when necessary. Finally, I applaud recent efforts by the securities lending community in the U.S. to begin publishing aggregated cash-collateral reinvestment data that reflect reinvestment return, interest-rate sensitivity, and liquidity and credit tiering. These are all positive developments. However, along with many of my colleagues in the private sector, I believe there still is a need for the market to develop and implement additional risk management techniques. Let me give you some examples of what I am thinking about. First, financial institutions must have the discipline to consistently apply robust risk management techniques through all phases of the business cycle. A concern for supervisors is the tendency of credit markets to steadily bid down spreads in the optimistic phase of the cycle, often to the point where returns no longer seem commensurate with risk. Then, as problems emerge, lenders in the credit markets pull back, causing spreads to reverse sharply.