What fraction of that residual exposure to the potential range of adverse events can and should the official sector try to protect the system against? The apparent success that market participants and supervisors have had so far in confronting these issues does not imply that the potential for systemic risk in financial markets no longer deserves the attention of central banks and supervisors. Although improvements in capital adequacy and riskmanagement tools seem to have been a key part of the increased resiliency we’ve seen in recent years, we can’t assume that the standards and risk-management practices consistent with stability in the recent past are the ones that will perform well in the future. This is partly because it is impossible to know for sure how the favorable macroeconomic conditions and the financial sector stability interacted and reinforced each other. That is, would financial sector outcomes be as favorable in a weaker macro environment? But probably more important is the fact that even as we have pushed forward on regulatory, supervisory and risk-management efforts, financial markets, instruments and institutions have continued to evolve as well. Among the most notable of these changes has been the rapid growth and innovation in derivatives and the greater relative importance of private leveraged financial institutions, such as hedge funds. The changes in credit markets that have accompanied the latest wave of innovation in derivatives and the large role played by leveraged financial institutions in those markets may exacerbate some of the traditional sources of challenges in financial markets.

An even greater challenge is measuring the exposure of the firm not simply to the direct effects of the failure of a particular hedge fund counterparty, but to the broader distress that it might cause to other market participants or its impact on the other exposures of the firm. The management of these direct and indirect exposures needs to be an important focus of attention. Capital and margin Supervisors have put a considerable amount of effort over the past decade into designing a successor to the Basel capital accord. The present regime does not do a good enough job of capturing the risks a major institution typically assumes today. Because it understates the amount of capital required against some risks, overstates others, and ignores still others, we should work to put in place a replacement regime as quickly as we can be confident we have a viable alternative. The prudent, conservative approach should be to move forward to a more risk sensitive framework that creates better incentives for prudent risk management, not to try to extend the life of the present accord. It is critical that these broader efforts to fix the capital regime be reinforced with more attention by supervisors to margin practice and limits around the counterparty risk-management process within the major financial institutions. The regulatory capital regime is designed to offset the effects on individual firms of lower margin. Where margin levels are low relative to potential exposure, the capital requirement is higher. Where margin is higher, the capital charge is lower.