In addition, expectations for increased investor demand for euro-denominated investments, together with the possibility of reduced participation by speculative and arbitrage trading accounts, are likely to have an effect on spreads of fixed-income securities to Treasuries. Traders in various fixed-income markets already have begun to note increased levels of spread volatility and expectations for higher absolute spreads relative to historical levels in response to these market dynamics. In this environment, managing market risk will become more difficult as the nature of fixedincome spread products changes. As we recently have learned, spread relationships that had endured for many years can break down suddenly, thereby increasing the already complex task of hedging positions. The increase in the liquidity premium for on-the-run Treasury securities last fall resulted in increased hedge-related activity in both the interest-rate swap and Treasury futures markets. Traders have continued to explore the usefulness of non-Treasury fixed-income securities as hedging vehicles. Risk managers must, therefore, be especially rigorous in analyzing their firms’ positions and hedging strategies, particularly when historical experience may not be as predictive a guide as it once seemed to be. I am encouraged by some recent market efforts to improve risk management practices. In lending, the risk-return discipline has been greatly enhanced at some international banks. These institutions have introduced measures to compare credit spreads with historical loss rates on well defined categories of credit. They also have enhanced the methods they use to assign internal risk ratings to individual credit exposures.

Better information about the credit risk profiles of the largest, internationally active banks, including the composition of their portfolio by internal ratings, would also be useful. A commitment to the use of advanced analytical tools, stress testing, and improved disclosure comes under the widely discussed rubric of seeking out and adopting industry-wide best practices. It is, perhaps, most important to note that the development of best practices is a dynamic, not a static, process that can only be enhanced by consistent risk management efforts over a long time horizon. In sum, I am led to conclude that diligent market discipline using techniques such as those I suggest here is in the long run the essential element needed to achieve both public and private goals. All market participants bear the difficult responsibility of determining and exacting adequate compensation for risk. While the public sector has a responsibility to increase the effectiveness of its overall regulatory and supervisory framework, it is the private sector’s continuous reassessment of risk and advancement of risk management techniques that ultimately will serve to preserve a safe and sound financial system while simultaneously rewarding individual institutions with long-term profitability. In the public sector, we can help markets work more effectively by ensuring that regulated financial institutions support the trading process by making sound credit decisions. We can also work to improve bank supervision by our ongoing examinations of bank risk measurement and management processes, a major focus of the examination process.