Moreover, because we’ve experienced such a variety of different types of stress, overall risk may be lower. But this recent history also suggests that we need to maintain a degree of humility and caution about our capacity to anticipate the nature and dynamics of future stresses to the financial system. How strong and resilient is the U.S. financial system today? Our sense is that the system is quite strong and resilient relative to the recent past. The major financial institutions at the core of the system are profitable and well capitalized. The total risk-based capital ratio for the ten largest U.S.-owned bank holding companies has averaged more than 12 percent over the past two years, a slight increase relative to prevailing levels since the mid-1990s. At year-end 2003, nearly every bank in the country met the regulatory standards to be considered “well capitalized”, with fewer than 100 - representing less than 1 percent of banking industry assets - failing to meet these standards. While risk-based capital ratios do not always provide an accurate picture of true capital strength, especially for the larger and more complex institutions, these statistics are nonetheless broadly indicative of a very strong underlying capital position of the industry. BIS Review 33/2004  1  Robust capitalization is important because capital, along with earnings, provides the first line of defense against losses. Counterparties and customers are less likely to lose confidence and pull back from a well-capitalized institution in the wake of a large loss or other negative event.

Among the legal advances are greater clarity on the enforceability of rights of netting and closeout in the event of default of a counterparty, better clarity in master documentation regarding rights and remedies, and better harmonization domestically and internationally of key provisions in different  2  BIS Review 33/2004  master netting agreements for different products that might hedge one another. These, combined with the wider prevalence of collateral arrangements overall, provide derivatives dealers greater protection in the event of counterparty default and expand their capacity to enter into transactions under normal market conditions. The development of new clearing arrangements has also strengthened the resiliency of the crucial payment and settlement systems that provide the backbone of the U.S. financial system. Existing payment and settlement systems also have implemented improved safeguards not only against the impact of the default of a system participant, but also against the potential impact of external events, such as those experienced on September 11. Overall, these changes suggest that, at a fundamental level, significant strides have been made in enhancing the resiliency of the U.S. financial system. High levels of overall capital, greater diversification of credit exposure, increased use of collateral, and the stronger payment and settlement system infrastructure make our financial system stronger today than it has been. With these favorable developments, however, come a range of challenges. I want to discuss a few of these and their implications. This is not meant to be, and is not, a comprehensive list. The first is the challenge of complexity.