With financial growth and innovation, we have seen a dramatic increase in the complexity of the risk management challenge. The frontier of innovation inevitably advances somewhat ahead of the pace of improvements in the risk management and supervisory infrastructure. The models used to inform credit judgments, to measure exposure, and to price risk in the newest instruments and trading strategies are by definition less grounded in experience. The process of assigning fair or market value is much more subjective and less amenable to objective verification. Consensus on the appropriate accounting treatment is less well established. As the complexity of risks has grown, so have the demands on firms to understand how exposures might evolve, especially in times of market stress. As an example, basis risk - in which hedged positions only partially offset one another - is an increasingly important concern for many firms, especially those that deal in complex products such as options. Assessing and managing these more complex risks requires risk management tools with a commensurate level of sophistication. In particular, the further development of techniques for stress testing and scenario analysis and of methods for translating stress test results into concrete risk management outcomes are important areas for additional progress. The risk management challenge is complicated by the nature of the institutions at the core of the system. Large, diversified financial institutions comprise many separate, highly specialized business units, each of which can have its own approach to tracking and managing risk exposures.

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.